What is ETF (Exchange Traded Fund)? And How to Invest in them?
Exchange Traded Fund or ETF is getting a lot of attention among the investing population lately because of the ease and flexibility it offers to the investors. It is a basket of securities like mutual funds but can be bought and sold through a brokerage firm on a stock exchange.
In this post, we are going to discuss what exactly is an Exchange Traded Fund and how to invest in them. But before we start discussing ETFs, let’s brush up the basics of mutual funds as they are somewhere related.
Mutual Fund is a financial product where a Mutual Fund company pools funds from its investors and in return, allot them units. The amount collected is invested in a portfolio of securities which are traded in the markets. Mutual Fund schemes are low-cost investment options which help you to plan your personal finance effectively. You can start investing in mutual funds with an amount as low as Rs 500 per month via SIPs. Through Mutual Funds, you can invest your savings across diverse asset classes, industries, and economies.
In Mutual Fund investing, you can either choose to be an ‘Active’ investor or opt for ‘Passive’ investing style. The Mutual Fund schemes where the underlying assets are frequently churned to outperform their benchmarks are known as active funds. Passively managed funds are those which replicate the portfolios of their benchmark indices.
ETFs are the best representatives of passively managed funds. Let’s have a discussion on ETF basics.
Exchange Traded Funds
An ETF or Exchange Traded Fund is a variety of Mutual Fund which tracks any particular index, be it an index of stock, commodity or any other security. ETF invests in a portfolio of assets of a specific nature. For example, you can invest in a Gold ETF or Bond ETF or Currency ETF.
ETFs trade in the stock exchanges and therefore can be bought and sold during market hours like any instruments listed in a stock exchange. The price at which an ETF is usually traded is close to its Net Asset Value (NAV). In order to invest in an ETF, you need to have your own Share Trading Account and Demat account.
You can earn income from your ETF investments in two ways. Firstly, you can earn in the form of dividends. The second one is that you can trade your ETF units like shares and generate income in the form of capital gains.
Some people have this doubt in their minds whether ETF is the same as Index Funds or not. Well, what is the reality then? Let’s dig deep into it.
ETF vs Index Funds
An Index Fund is also a variety of Mutual Fund like ETF. The portfolio of an Index Fund is built in such a manner that its components look similar to that of a specific stock market index. An index fund aims in replicating the performance of a particular benchmark index.
On the other hand, an ETF is a special form of Mutual Fund consisting of similar securities, falling under any specific market index. An ETF is the only type of Mutual Fund which is traded like shares in a stock exchange. Its composition is similar to any index like Sensex or Nifty.
So, both ETF and Index Fund look quite similar except the fact that the ETF is traded in the stock market.
Is this the only difference between the said two investment options? The answer is a big no. Let’s have a look at some more key differences between the two:
- You can invest in an Index Fund only during a specified time in a day. But, you would be happy to know that you can trade in the ETFs throughout the day.
- The price of any ETF keeps fluctuating throughout the trading hours. On the other hand, the price of an Index Fund is fixed only at the end of the trading day.
- The basis for the pricing of an ETF is the demand and supply of the same in the market. Whereas, the pricing of an Index Fund depends on its NAV.
- To invest in an ETF, you will have to incur expenses in the form of brokerage. But, for investing in an Index Fund, there is no such transaction charge applicable.
- The expense ratio of an ETF is comparatively lower than that of an Index Fund.
- If you want to invest in an ETF in the Indian market, the minimum investment required is Rs.10,000. Whereas, you can invest in an Index Fund by paying a minimum lump sum of Rs.5,000. Moreover, you can choose to invest in the Index Funds with a minimum amount of Rs.500, if you choose the SIP (Systematic Investment Plan) route. Please note that investing in an ETF via SIP is not applicable.
Why you should invest in an ETF?
The next question that can come to your mind is why you should invest in an ETF? I can state a couple of reasons in favor of this.
Investing in an ETF is certainly convenient. Buying and selling an ETF unit can be done by having a look at the market price available on the trading platform. The exchanges where the ETFs are listed are well regulated by the concerned authorities. This has resulted in increasing transparency in the trading of ETFs.
Furthermore, you can choose to invest in ETFs as the expense ratio is much lower than any other Mutual Fund. Again, if you are unable to figure out which stocks to invest in, you can invest in a sector-specific ETF instead with a small corpus.
(Updated till 2nd May 2019 | Source: Moneycontrol)
How to invest in ETF in India?
In order to invest in an ETF you need to ensure the following two things:
- You are mandatorily required to open a Share Trading Account with any Stock Broker/ Sub-broker.
- You must also possess a Demat Account in your name for the purpose of holding the ETF units which you are going to buy.
Now, to apply for the above two things, you have to submit the following documents for complying with the KYC (Know Your Customer) norms:
- A copy of your Passport, Driving License, or PAN Card as your identity proof.
- A copy of your Passport or any Utility bill as a proof of your address.
- A copy of your Bank Account statement for the last 6 months.
After you have got access to your online trading platform, you can carry out any ETF transaction. You can invest in ETFs via any of the following two modes:
- You can place your order in the market through the online trading terminal provided to you. Trading in ETFs is no different than carrying out transactions with respect to stocks listed in the stock market.
- The second option is that you can place your order by calling your Broker over the phone and let them know about your trade requirements.
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If you are willing to take part directly in the stock market but unable to figure out which security to pick, you can start investing with ETFs. In case you are an existing investor in the market and looking to try something different, you can look to include ETFs in your portfolio.
In India, people are still predominantly interested in investing in traditional saving schemes like PPF, FD, and NSC. Stock Market investing is yet to get popular among the Indians at a significant level. Not even ten percent of the income earners in our nation are having their Stock Trading Accounts. Therefore, there is no doubt in saying that the number of participants in ETFs in our economy is still pretty less.
AMFI has been working hard in the last few years to popularize the concept of Mutual Fund investing in our country. So, as the Indian Mutual Fund industry grows, it is expected that more and more investors will show an inclination towards ETFs.