Investing in stocks through the mutual fund route is both convenient and effective. However, as the number of mutual funds increases, it becomes difficult to choose the right one. And, keeping in mind the fact that studies have shown that it is difficult to outperform the market, one feels compelled to rethink the whole exercise of choosing the right fund. Indeed, it would be much easier and more lucrative to simply invest directly in an index.
Mutual funds that enables an investor to invest in the index are called index funds.Such funds invest their portfolios only in stocks that comprise a particular index, in the same proportion in which they are represented in the index. As a result, the performance of such funds mirrors the performance of the index. The mutual fund sector in India has a variety of such funds, so investing in an index is truly within your reach.
In fact, the mutual fund sector goes a step further to offer you funds that not only mirror an index but whose units can be traded on the stock exchange in much the same way as a common stock. These funds are called Exchange Traded Funds or ETFs.
What are Exchange Traded Funds (ETFs)?
Exchange Traded Funds (ETFs) are open-ended investment funds listed and traded intraday on a stock exchange. They aim to track the performance of an index and provide access to a wide variety of markets and asset classes.
Why invest in ETFs?
While many investors have similar outlooks, no two are exactly alike. Due to the unique structure of ETFs, all types of investors, whether retail or institutional, long-term or short-term, can use it to their advantage without being at a disadvantage to others. They allow long-term investors to diversify their portfolio at one shot at low cost and insulate them from short-term trading activity due to the unique “in-kind” creation / redemption process. They provide liquidity for investors with a shorter-term horizon as they can trade intra-day and can have quotes near NAV during the course of trading day. As initial investment is low, retail investors find it simple and convenient to buy / sell. They facilitate FIIs, Institutions and Mutual Funds to have easy asset allocation, hedging, equitising cash at a low cost. They enable arbitrageurs to carry out arbitrage between the Cash and the Futures markets at low impact cost.
ETFs provide exposure to an index or a basket of securities that trade on the exchange like a single stock. They offer a number of advantages over traditional open-ended index funds as follows :
- Efficiency: Annual management fees for ETFs are generally less than 1%, enabling investors to obtain cost-efficient exposure to a diversified portfolio of securities through a single transaction.
- Transparency: Investors have ready access to the component securities represented in an ETF. Moreover, market prices are published real-time throughout the trading day.
- Flexibility: An investor can buy and sell ETFs anytime during trading hours and may employ the traditional trading techniques including stop orders, limit orders, margin purchases, and short sales.
What are the risk considerations before investing in ETFs?
Like any investment product, ETFs too are not free from risks. Investors should note the following risks associated with ETFs:
- Market risk: An ETF represents interest in a portfolio of securities. Hence, the performance of the ETF will be directly affected by the performance of its constituent securities.
- Tracking error: An ETF may not be able to exactly replicate the performance of the underlying index due to management fees, timing differences and other factors.
- Foreign exchange risk: Investors whose base currency is other than the currency denomination of the ETF will be subject to the risk of fluctuations in currency values.
Investment applications that can be adopted with ETFs
ETFs are simple tools with many applications, some of which are outlined below:
- Asset allocation: ETFs can be used to fill voids in a portfolio as they provide an efficient and diversified way to gain access to specific markets or asset classes.
- Targeted exposure: ETFs are ready vehicles for investors seeking to take positions based on their views on a particular markets returns.
- Hedging: ETFs can be used to hedge against other investment positions. For instance, an investor may long a specific market segment while at the same time shorting an ETF.