If you take a look at exchange traded funds, these are a unique investment tool that offers the best of two distinguished assets – the trading liquidity of stocks and diversification of mutual funds.
Defining Exchange Traded Funds
Also referred to as ETFs, exchange traded funds are open ended schemes that invest the majority of their investible corpus in the underlying securities of the index/benchmark that they track. As per market regulator SEBI guidelines, ETFs should invest a minimum of 95% of their total assets in the underlying benchmark. These funds try to generate returns that are close to how the index performs, but with minimum tracking error.
How do Exchange Traded Funds work?
When you invest in an exchange traded fund, you get exposure to a wide range of stocks that comprise the index. For example, if exchange traded fund tracks NIFTY 50 as its benchmark, the fund will invest in all the securities that comprise the benchmark, in the same fashion, without changing portfolio composition. They have passively managed funds that work in a slightly different fashion than other mutual funds. For example, both ETFs and other mutual funds invest in a pool of securities from the financial resources collated from investors sharing a common investment objective. These funds are designed to track the performance of the benchmark to generate similar returns. Unlike other mutual fund schemes that outperform the underlying benchmark, ETFs try to mimic the performance of the underlying securities of their benchmark and try to generate similar returns that are subject to tracking error.
How can ETFs add value to your portfolio?
Exchange traded funds give investors an exclusive equity market exposure. If you are someone who wants to invest in the stock market but fear that you might make a wrong investment decision, ETFs can help you understand how markets work. Also, since these are passive funds, they are cost effective and carry a low expense ratio as opposed to active funds that have a high expense ratio. Exchange traded funds have an expense ratio that is usually below 1% whereas other mutual funds may have an expense ratio that may go up to 2.25%.
Since you will be investing in a scheme that has a low expense ratio, your investments in ETFs can prove cost effective. Investing in a cost effective scheme is always good for an investment portfolio. Also, they are highly liquid in nature. Investors can do intraday trading with ETFs. However, they need to have a DEMAT account to store their bought ETF units. Since ETFs are traded at the stock exchange for their live market price during trading hours, investors need to have a trading account as well as DEMAT account. They can either take the long term investment approach or they can indulge in intraday investing as well.
ETFs are best suited for anyone who does want their mutual fund returns to be affected by human biases. When markets turn volatile, some investment decisions that the fund managers take can prove to be volatile for the investments. In such a scenario, ETF investors do not have to worry as their portfolio will remain the same and might be able to handle market volatility in a better way. Also, one does not need for the ETFs NAV to conclude for the day to trade in them. They do not have to place a buy or sell request to the fund house, unlike mutual funds that can only be traded at their NAV that is determined at the end of the day.