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Exchange Traded Funds (ETFs) - What are, How to Invest, & Pros

An Exchange Traded Fund (ETF) is an investment vehicle that combines the features of both stocks and mutual funds. It provides investors with an opportunity to gain exposure to a diversified portfolio of assets, such as stocks, bonds, or commodities, through a single traded security. 

Exchange Traded Funds are made to track the performance of a specific index, sector, or asset class. Unlike mutual funds, ETFs trade on stock exchanges like individual stocks, offering liquidity and intraday trading flexibility. Let’s grasp the basics of this increasingly popular investment option.

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What are Exchange Traded Funds (ETFs)?

Exchange-Traded Funds (ETFs) are like a basket of different things you can invest in – like stocks, bonds, commodities, or other kinds of investments. When you put your money in an ETF, you’re buying a small piece of this basket.

ETFs can be categorized in two ways on the basis of their way to perform: 

Passive ETFs: These are like a mirror that tries to reflect what’s happening in a specific part of the market. For example, if there’s an ETF for the technology sector, it will try to perform just as well as the technology market does.

Active ETFs: These have a person or a team making decisions, trying to do even better than the market. They are constantly buying and selling different things in the ETF to try and get the best return.

Although ETFs might sound a bit like mutual funds, they have some differences. One key difference is when you can buy or sell them. Like stocks, you can buy or sell ETFs any time during the day. On the other hand, you can only buy or sell mutual funds at the end of the trading day.

ETFs provide investors with a convenient way to access a broad range of investment options. This allows for diversification, potential returns, and flexibility in buying and selling throughout the trading day.

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Types of ETFs

Types of ETFs

ETFs come in various types, catering to different investment objectives and strategies. Here are a few common types of ETFs:

  • Equity ETFs: These ETFs invest primarily in stocks, providing exposure to specific markets, sectors, or indices. They allow investors to diversify their portfolios across a range of stocks without directly owning individual shares.
  • Bond ETFs: Bond ETFs focus on fixed-income securities like government, corporate, or municipal bonds. They offer investors access to the bond market’s potential income and provide diversification within the fixed-income asset class.
  • Commodity ETFs: Commodity ETFs invest in physical commodities like gold, silver, oil, or agricultural products. They enable investors to gain exposure to commodity prices without directly owning the physical assets.
  • Sector ETFs: Sector ETFs concentrate on specific industry sectors, such as technology, healthcare, or energy. With sector ETFs, investors can target sectors they believe will perform well or add sector-specific diversification to their portfolios.
  • International ETFs: International ETFs invest in stocks or bonds of companies or countries that lie outside the investor’s home country. They offer exposure to global markets and let investors diversify geographically.

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How Do ETFs Work?

How do ETFs work

Let’s understand how ETFs work with an example. 

Example

Imagine an ETF called ABC Market Index Fund that aims to track the performance of the ABC Market Index. 

This index represents a basket of 100 top-performing stocks in the market. Now, when investors buy shares of the ABC Market Index Fund, the ETF provider uses the invested capital to purchase a proportional amount of shares from the 100 underlying stocks in the ABC Market Index. 

By doing so, the ETF mirrors the performance of the index. Throughout the trading day, investors can buy or sell ETF shares on stock exchanges, and the ETF’s price fluctuates based on the value of the underlying stocks. 

This mechanism allows investors to gain exposure to a diversified portfolio of stocks through a single investment.

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How to Invest in ETFs?

Making investments in ETFs is a straightforward process. The following steps will help guide one with investments in ETFs:

  • Research and Select an ETF: The first step is to research different ETF options that align with your investment goals. Factors such as the underlying assets, expense ratio, performance history, and the fund’s objective must all be taken into consideration. Identify ETFs that match your risk tolerance and investment strategy.
  • Choose a Brokerage Account: Open a brokerage account with a reputable financial institution or online brokerage platform that offers access to a wide range of ETFs. Ensure the brokerage provides a user-friendly interface, competitive commission ETF fees, and reliable customer support.
  • Fund Your Account: Once your brokerage account is set up, deposit funds into it. You can transfer money from your bank account to the brokerage account or initiate an electronic funds transfer. Some brokerages also allow you to invest in ETFs through regular contributions or automatic investment plans.
  • Place a Trade: Using the brokerage’s trading platform, search for the desired ETF by its ticker symbol or name. Review its current market price and historical performance. Decide whether you want to buy ETF shares at the market price or set a specific limit order.
  • Monitor and Manage Your Investment: After purchasing ETF shares, it’s essential to monitor your investment periodically. Keep an eye on the performance of the ETF and any changes in its underlying index, and review your investment strategy as needed. Consider rebalancing your portfolio if required.
  • Selling ETF Shares: When you decide to sell your ETF shares, log into your brokerage account and place a sell order for the desired quantity. The shares will be sold at the prevailing market price. Make sure to review any tax implications before selling.

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Here are some of the most popular Exchange Traded Funds to buy in India in 2023:

  • Index ETFs: These ETFs track a specific index, such as the Nifty 50 or the Sensex. They are a good way to get broad exposure to the Indian stock market. Some popular index ETFs in India include:
    • HDFC Sensex ETF
    • UTI Nifty ETF
    • SBI ETF Sensex
    • Motilal Oswal Nifty 50 ETF
  • Sector ETFs: These ETFs focus on a particular sector of the economy, such as IT, healthcare, or banking. They can be a good way to gain exposure to a specific sector that you believe is undervalued or has good growth potential. Some popular sector ETFs in India include:
    • Nippon India IT ETF – It is also one of the best low-cost ETFs.
    • SBI Healthcare ETF
    • Axis Bank ETF
    • ICICI Prudential Nifty Bank ETF
  • Gold ETFs: These ETFs track the price of gold. They can be a good way to diversify your portfolio and protect your investments against inflation. Some popular gold ETFs in India include:
    • IDBI Gold ETF
    • Invesco India Gold ETF
    • Aditya Birla Sun Life Gold ETF
    • SBI ETF Gold
  • Real estate ETFs:

These ETFs invest in securities that are given by companies that invest in real estate projects.

Some popular Real estate ETFs include:

  • Embassy Office Parks REIT
  • Mindspace Business Parks REIT
  • Brookfield India Real Estate Trust

Pros and Cons of  ETF Investing

It’s important for investors to consider these pros and cons, along with their individual investment goals and risk tolerance, before making investment decisions regarding ETFs.

Pros of Investing in ETFs

  • Diversification: ETFs offer instant diversification by holding a basket of securities, such as stocks or bonds. This ETF diversification helps mitigate the risks associated with investing in individual securities by spreading the investment across different assets.
  • Liquidity: ETFs engage in trading on stock exchanges throughout the day, allowing investors to buy or sell shares at market prices. ETFs provide liquidity and flexibility, thereby enabling investors to enter or exit positions easily.
  • Lower Costs: Typically, ETFs tend to have lower expense ratios compared to mutual funds. Since they passively track an index, they don’t require active management, resulting in reduced management fees.
  • Transparency: ETFs disclose their holdings on a daily basis, enabling investors to know exactly which securities are held within the fund. This transparency helps investors make informed decisions based on the underlying assets.
  • Tax Efficiency: ETFs are structured in a way that can minimize capital gains distributions, leading to potential tax advantages. Due to their unique creation and redemption mechanisms, ETFs can manage capital gains more efficiently than traditional mutual funds.

Cons of Investing in ETFs

  • Market Volatility: ETFs are contingent on market volatility; their prices can fluctuate based on supply and demand dynamics. During periods of high market volatility, ETF prices may deviate from their net asset value (NAV).
  • Tracking Error: While ETFs aim to track the performance of a specific index, there can be slight discrepancies between the ETF’s performance and the index it tracks. This tracking error can be attributed to factors such as fees, sampling techniques, and market conditions.
  • Limited Control: When investing in an ETF, investors have limited control over the specific securities within the fund. The portfolio composition is predetermined by the fund manager, which means that the investors cannot customize their holdings based on individual preferences.
  • Trading Costs: Although ETFs have lower expense ratios, investors may incur trading costs, such as brokerage commissions, when buying or selling ETF shares. Frequent trading can increase transaction costs and erode overall returns.
  • Inherent Risks of Underlying Assets: The risks associated with the underlying assets an ETF holds affect the said ETF. For instance, an equity ETF that tracks a specific industry is negatively affected by any adverse developments in that industry.

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Here are some of the best most popular ETFs to buy in India in 2023:

  • Index ETFs: These ETFs track a specific index, such as the Nifty 50 or the Sensex. They are a good way to get broad exposure to the Indian stock market. Some popular index ETFs in India include:
    • HDFC Sensex ETF
    • UTI Nifty ETF
    • SBI ETF Sensex
    • Motilal Oswal Nifty 50 ETF
  • Sector ETFs: These ETFs focus on a particular sector of the economy, such as IT, healthcare, or banking. They can be a good way to gain exposure to a specific sector that you believe is undervalued or has good growth potential. Some popular sector ETFs in India include:
    • Nippon India IT ETF – It is also one of the best low-cost ETFs.
    • SBI Healthcare ETF
    • Axis Bank ETF
    • ICICI Prudential Nifty Bank ETF
  • Gold ETFs: These ETFs track the price of gold. They can be a good way to diversify your portfolio and protect your investments against inflation. Some popular gold ETFs in India include:
    • IDBI Gold ETF
    • Invesco India Gold ETF
    • Aditya Birla Sun Life Gold ETF
    • SBI ETF Gold
  • Real estate ETFs:

These ETFs invest in securities that are given by companies that invest in real estate projects.

Some popular Real estate ETFs include:

  • Embassy Office Parks REIT
  • Mindspace Business Parks REIT
  • Brookfield India Real Estate Trust

Conclusion

In conclusion, Exchange Traded Funds (ETFs) offer a flexible and convenient investment option by mirroring the performance of an underlying index or asset class. Despite the advantages they provide, investors should be mindful of potential drawbacks. By following straightforward steps, investors can readily engage in ETFs and capitalize on their potential. ETFs serve as a dynamic tool to navigate the realm of finance and construct a diverse portfolio.

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