Exchange Traded Funds (ETF)- Meaning, Benefits, Limitations & Best ETFs

Mutual Funds which are listed and traded on stock exchanges like shares are known as Exchange Traded Funds (ETFs). Read more for a better understanding of what are ETFs, how do they work, advantages of ETFs and more-

What are Exchange Traded Funds

ETFs or Exchange Traded Funds are a type of pooled investment funds which invest in diversified securities such as equities, bonds, commodities that track an underlying index.

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An ETF passively tracks an index like the Sensex or Nifty by holding securities in the same weights as the Nifty/Sensex. ETFs can be traded anytime in the market but you need a demat account to invest in an ETF and execute buying or selling transactions.

Benefits of Investing in ETFs

• Low Cost

The biggest advantage of investing in ETFs is cost efficiency. The expense ratio of an ETF is usually less than 0.5% compared to 2-2.5% for actively managed equity funds. A lower fund management fee generates incremental savings which can result in increased payouts in the long-run.

• Liquid

Since ETFs are marketable securities, they can be traded on registered bourses. Since an ETF can be bought and sold at any time in the day (during trading hours) it is more liquid compared to other investment products such as mutual funds or PPF. One reason is that the price/NAV of an ETF can fluctuate throughout the day. On the other hand, a mutual fund is usually bought/sold directly with the fund house at the declared NAV of the day.

• Transparent

As ETFs track an underlying index, you know beforehand which stocks it will hold and in what proportion. For example, the Nifty 50 is composed of the 50 largest listed companies in India by market capitalisation. An ETF tracking the Nifty 50 will hold these exact companies and in the same weights as the Nifty. It will also rebalance its holdings when the Index composition changes.

• No Fund Manager Error Problem

Since an Exchange Traded Fund tracks an Index, it does not rely on active investment calls provided by a fund manager. Hence it is not affected by the errors that a fund manager might make. It can sometimes have an error in tracking the index (called tracking error), but this is usually small in magnitude and therefore, can be ignored.

• Efficient Market Hypothesis

According to the Efficient Market Hypothesis, no fund manager can outperform the market forever and outperforming strategies are quickly imitated and arbitraged away. Hence in the long run, simply investing in the whole market passively tends to outperform active stock picking. If you believe in this financial theory, ETFs are a better product than actively manages funds.

• Diverse Products

ETFs in India track diverse products like the Nifty, Gold, Nifty Next 50, Nifty Low Vol 20 Index and several others. You may not find active mutual funds tracking all these products.

Also Read:- 10 Common Mutual Fund Investment Mistakes to Avoid

Limitations of ETFs

• Giving up Alpha

An ETF investor is giving up the potential to outperform (called alpha) since he is only passively tracking the index. An actively managed fund can not only give you the index return but also beat it especially in emerging markets such as India.

• Limited Growth Upside

Usually, only mature companies make it to indices like the Nifty or Sensex. Such indices only include the largest companies by size and many of these companies have put their best years of growth behind them. So ETF investments cannot tap the opportunities to earn higher returns in high growth potential companies in small and mid-cap space.

• Need Demat and Trading Account

Since ETFs require demat and trading accounts, investing in them is not practical for investors who do not have such accounts. Many mutual fund investors do not have such accounts since they are not required for investing in ordinary mutual funds.

Equity ETFs

(Data as on December 10, 2019; Source: Value Research)

Debt ETFs

These ETFs hold liquid debt securities as the underlying asset which are less riskier but provide moderate returns.

(Data as on December 10, 2019; Source: Value Research)

Gold ETFs

These ETFs typically hold physical gold as the underlying asset. Despite being low on returns it is popular because investing in gold has been considered to be a safe investment option for decades.

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Also Know What is Difference Between ETF vs Index Funds

List of Exchange Traded Funds to Invest

(Data as on December 10, 2019; Source: Value Research)