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What is an Exchange Traded Fund (ETF) and How Does it Work?
Mutual funds have been quite popular among investors and financial enthusiasts due to their significant returns and benefits.
However, many individuals seek an alternative that requires low management fees and offers lucrative day trading opportunities.
Exchange-traded funds are an option that can help individuals fulfill their financial goals.
Keep reading to learn more about ETFs and how to invest in them.
Table of Contents
What is ETF?
An ETF, or exchange-traded fund, was introduced in 1993 as a basket of securities. These funds mirror the investment style of a popular index, such as Sensex and Nifty 50, and try to replicate the returns.
ETFs pool multiple investors' funds and invest them in tradable assets such as debt securities, bonds, shares, and derivatives.
These ETFs are registered with SEBI, or the Securities and Exchange Board of India. Individuals can buy and sell ETFs on stock exchanges via a broker.
An interested investor can invest in multiple ETFs without any restrictions. Individuals looking to park their savings can easily invest during market hours. ETFs are highly liquid, which allows investors to offload the units when necessary.
Individuals should have a clear understanding of ETFs and their function to make an informed decision. In this regard, having an idea of the types of exchange-traded funds will be beneficial.
How Does an ETF Work?
ETFs are similar to mutual funds in characteristics and function. However, as noted above, investors can buy or sell ETF units on stock exchanges (BSE, NSE, etc.) during market hours.
The price of the underlying assets in an ETF’s portfolio directly influences its net asset value (NAV). In other words, if the price of the stocks that an ETF invests in falls, the NAV of the ETF will also decrease.
Let’s check ETF benefits to understand this concept better.
Types of Exchange-traded Funds in India
Following is a table enlisting the different types of ETFs available in the market and their respective functions.
Now that you are aware of the different ETF types and what ETFs are, you must know how they work.
Benefits of Investing in ETFs
Here are some benefits of investing in the best ETFs in India:
1. Diversification
ETFs provide investors with diversification across various horizons, including styles, sectors, and commodities around the world.
2. Low-cost option
As per SEBI, the expense ratio cannot be more than 1% for ETFs, which is lower than the limit of actively managed funds. Since ETFs are passively managed, the fund managers do not need to carry out thorough analysis and research. Hence, they charge low management fees.
3. Transparency
There is complete transparency about the portfolio constituents of ETFs. These investment vehicles report NAV and holdings daily.
Who Should Invest in Exchange-traded Funds?
The following can invest in ETFs:
- Individuals seeking exposure to a particular currency, sector, or asset class at a lower cost than actively managed funds.
- Investors seeking diversification across different horizons.
- Individuals looking to generate passive income.
How to Invest in ETFs?
Investors need to fulfill certain formalities to purchase ETF units without hassle. They have to have a Demat account with a broker to buy and sell the units.
Individuals wondering, “How can I invest in ETFs?” should consult a professional for suggestions. Ideally, there are two ways to invest in ETFs.
- An individual can connect with a broker through a call and place an order and inform him/her about the buy or sell order.
- One can also check the online trading terminals and place an order to purchase or sell ETF units.
However, before investing, individuals should check certain factors related to ETF for an informed decision.
Things to Consider Before Investing in ETFs
These are some factors that investors can consider before purchasing ETF units. This will help them make the most out of the advantages of exchange-traded funds.
1. Soft Impact Cost
It is an indirect expense of purchasing or selling a share. Here, the impact price will be lower as an indirect cost to an investor will be less. There are chances of an increase in purchasing costs as underlying security prices fluctuate.
2. Liquidity
Liquidity is an essential factor that allows investors to sell and buy in a stock exchange. The ETFs with higher liquidity have a lower bid-ask spread. Comparatively, inferior liquidity would have a wider spread. Hence, it is beneficial to invest in higher liquidity ETFs.
3. Benchmark
Individuals should decide the sector or market segment they want to invest in. Depending on it, they can select the index to replicate. They can choose a sectoral ETF that focuses on stocks of a particular sector or a benchmark index.
4. Tracking Error
It is a typical deviation of the variance in returns between an index and ETF. Individuals should always opt for ETFs with lower tracking errors to achieve their investment objectives.
5. Expense Ratio
This is the yearly fee ETF charges to cover its expenses. These charges include management fees, operating costs, fund expenses, and asset-based costs.
6. AUM
Assets Under Management (AUM) refers to the overall value of the underlying financial instruments. An ETF’s AUM can change depending on the price of the portfolio constituents.
Individuals should know that exchange trade funds with higher AUM have higher liquidity.
These data are vital to understanding exchange-traded funds and their operation. Individuals planning to invest in this fund should read the terms thoroughly or consult a professional for advice. This will help in making an informed decision.
Disclaimer: The information provided on this website is for general informational purposes only and should not be construed as financial, investment, or legal advice. While we strive to provide accurate and up-to-date content, we do not guarantee the completeness, reliability, or suitability of the information for your specific needs.
We do not promote or endorse any financial product or service mentioned in these articles. Readers are advised to conduct their own research, consult with financial experts, and make informed decisions based on their unique financial circumstances. Any reliance you place on the information provided here is strictly at your own risk.
FAQs about Exchange Traded Funds
What is the function of NAV in ETFs?
Can I invest in an ETF without a Demat account?
Other Important Articles about Mutual Funds
Disclaimer
- This is an informative article provided on 'as is' basis for awareness purpose only and not intended as a professional advice. The content of the article is derived from various open sources across the Internet. Digit Life Insurance is not promoting or recommending any aspect in the article or its correctness. Please verify the information and your requirement before taking any decisions.
- All the figures reflected in the article are for illustrative purposes. The premium for Coverage that one buys depends on various factors including customer requirements, eligibility, age, demography, insurance provider, product, coverage amount, term and other factors
- Tax Benefits, if applicable depend on the Tax Regime opted by the individual and the applicable tax provision. Please consult your Tax consultant before making any decision.
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