What are ETFs

Many informed investors have a thorough knowledge of how mutual funds work and what are the advantages and disadvantages of buying them. But very few have the same level of knowledge of ETFs. So in this article, we will try to answer what ETFs are. So let’s jump right in.

ETF is an acronym for Exchange Traded Funds. As the name suggests, you can buy and sell ETFs on an exchange. Well, that did not help. Right? So, let’s try again.

ETFs: Simple Meaning

ETF is a pooled investment vehicle that invests in a basket of securities.

A pooled investment vehicle is one in which multiple investors are involved. Each investor makes a contribution to the pool. This pooled money is then invested in a basket of securities by the Fund Manager. Investors in the pool (in our case, the ETF) get allocation to units in proportion to their contribution to the pool, and each unit has a Net Asset Value (NAV). We have simplified this concept in the table below. For the calculation of the table, we have assumed that NAV is Rs. 5. You can find the detailed explanation of NAV here.  

As the NAV is Rs. 5 and the total pooled amount is Rs. 1000, the total number of units will be 200.

This is very similar to Mutual Funds. Right? But ETFs bring in the added flexibility – units of ETFs can be bought or sold on a stock exchange during market hours just like regular stocks and unlike normal Mutual Funds.

As ETFs can be traded during market hours, their prices change throughout the trading session. Mutual Funds, on the other hand, can be bought or sold at only one price – end-of-day NAV.

But this is not the only difference. We have summarized all the differences in this article.

Most ETFs are set up to track the performance of a particular benchmark index (the objective of the pooled investment). For example, the UTI Nifty 50 ETF tracks the performance of the Nifty 50 Total Return Index (TRI). An investor who buys units of the UTI Nifty 50 ETF is essentially buying exposure to the Nifty 50 Total Return Index. Similarly, an investor who wants to take exposure to gold can buy the Nippon India ETF Gold BeES, which has been set up to track the INR price of gold. This is similar to index funds. But again, index funds are not tradable on the stock exchange.

Most ETFs are passively managed – the objective is to track the performance of the benchmark index. However, of late, smart-beta and actively managed ETFs have also gained popularity (more on this here) 

FAQs

Are ETFs better than Index Funds?

As both types of funds generally track different indexes, both options are good for a long-term investor. But if you prefer higher liquidity in the short term and own a Demat account, ETFs might be a suitable choice.

In which asset classes can I invest by buying ETFs?

You can invest in equities, debt, and commodities using ETFs. There are various sub-categories of ETFs as well. For example, sectoral ETFs for equities and gold and silver ETFs for commodities

How do I buy and sell ETFs?

Just like stocks, ETFs can be purchased and sold through a brokerage account. By calling your broker or using the online platform of your broker, you can place orders to buy or sell ETF units.