Exchange Traded Funds – Meaning, types, and benefits

If you are someone who has always wanted to invest in the stock markets but have been worried about the market volatility as well as selecting the right stocks, then it is time that you consider investing in Exchange Traded Funds (ETFs). ETFs are a type of pooled investment securities, which are traded on the stock exchange. They are effectively a basket of securities, whose value is derived from the combined value of all the securities within the basket. ETFs share the properties of stocks as well as mutual funds, in that they are pooled investments just like mutual funds, but they are also traded on the stock exchange, just like stocks.

How do Exchange Traded Funds work?

An ETF consists of multiple underlying tradable securities such as stocks, bonds, commodities, and currencies. As the prices of the underlying securities keep changing across the day, so does the price of the ETF, in the exact proportions.

For example, if we were to look at an ETF which replicates the Nifty50 Index, it would comprise the same 50 stocks in the index, with the same proportions. Thus, if the Nifty50 Index went up or down by 5%, so would the ETF by around 5%, respectively. Here, it is important to note that the change in the value of the ETF would be around the same as the underlying index and not exactly the same. The small difference reflects tracking error and transaction costs.

Exchange Traded Funds Meaning

ETF meaning Exchange-Traded Fund is a type of investment fund that trades on stock exchanges just like a stock. These are designed to provide investors with exposure to a diversified portfolio of assets, such as stocks, bonds, commodities, or a combination of these.

If you are curious about Exchange Traded Funds’ meaning, you should know that these are similar to mutual funds, in that they pool money from investors to buy a basket of assets. However, there are several differences between the two. Firstly, ETFs trade on stock exchanges like a stock, while mutual funds are bought and sold at the end of each trading day at the NAV (Net Asset Value). Now that you know ETF funds meaning, you should also know that ETFs can be bought and sold throughout the trading day, just like stocks.

When considering ETF funds meaning, please note that ETFs are usually passively managed, meaning that they track a particular index or benchmark, and seek to replicate the returns of that index or benchmark. Mutual funds, on the other hand, can be actively managed or passively managed, and may have different investment objectives and strategies. ETF meaning also involves the fact that these schemes can provide investors with a range of benefits.

Types of Exchange Traded Funds

ETFs are broadly categorised between Active and Passive; Active ETFs are managed by portfolio manager who constantly evaluates the market conditions and updates the basket of underlying securities, while Passive ETFs track / replicate a specific index wherein securities are rebalanced only when they are removed from the index.

In India, the following ETFs are predominant:

• Equity ETF - An ETF comprising a basket of shares of various listed companies, including and not limited to an index, a sector, a theme, a geography, etc.
• Debt ETF - An ETF comprising a basket of tradable debt instruments such as government debt, corporate debt, short-term paper, etc. Debt ETFs usually provide regular income to the investors
• Commodity ETF - An ETF comprising investments in physical commodities, such as gold, silver or crude oil. For example, a Gold ETF will invest in physical gold assets and track its prices while similarly, a silver ETF will give you exposure to the price movements of silver.
• Currency ETF - An ETF which tracks the performance of currency-pairs, and is dependent upon economic & socio-political events in the domestic and international markets

Advantages of ETFs

There are several advantages of investing in ETFs. Some of these include:

• You can gain access to an already-diversified pool of securities from the get-go, thereby significantly reducing overall portfolio risk
• As ETFs can be traded on the stock exchange, they are highly liquid instruments which can be bought or sold during the course of a trading day
• Investing in ETFs can lead to lower costs as ETFs are generally not subject to high expense ratios on account of lower management costs

Disadvantages of ETFs

On the other hand, just like there are two sides to every coin, ETFs do have a few limitations of which you need to be aware.

• You would require a demat account and a trading account to transact in ETFs.
• You will be subject to brokerage charges, demat charges, and securities transaction tax (STT) to purchase / sell ETFs via the stock exchange
• ETFs are subject to market volatility as they are tradable securities listed on the stock exchange, and are as sensitive to market
• As a result of being highly diversified instruments which invest in popular stocks, ETFs limit your ability to generate alpha

Gold ETF vs Gold Fund

The advantages of ETFs far outweigh the disadvantages and most investors can consider investing in ETFs. From that perspective, you might have asked yourself the question whether you should invest in a Gold ETF or a Gold Fund. Below, some insights into what might be a better option for you.

Gold ETFs invest in physical gold as the underlying and are highly sensitive to even slight movements in gold prices. Gold Funds are mutual fund schemes which invest directly and indirectly in gold, including physical gold, gold reserves, entities involved in producing and distributing gold, entities involved in mining gold, or even in Gold ETFs. So, depending on the type of exposure you want and the relative ease of investing that you would prefer, you can opt for either of the approaches to gain exposure to gold price movements.

Exchange Traded Funds have enabled the common investor to gain active exposure to highly diversified securities at a considerably low cost and with much less effort. They have thus become a point of entry for new investors with low to mild risk-appetites to gain exposure to securities markets, while generating more than commensurate returns.

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