Basics of Exchange-Traded Fund Explained: To understand what is an ETF (Exchange-Traded Fund) it is imperative for us to first understand the concept of Investing in a Fund, in detail.
‘Investing via funds’ simply implies investing in a large pool of money and which in turn is invested and managed by a fund manager. The funds are managed by experienced professionals, whose sole job is to manage the money in this fund.
Professional management ensures that the money is invested after careful analysis and planning. And the maximum return is generated for the fund. Now, through this write-up, we will try and understand the concept of Exchange-Traded Fund in detail.
What Is an Exchange-Traded Fund?
ETF, unlike any other Mutual Funds, trades like a regular share in the stock market. The ETF is a combination of various stocks which are listed on a stock exchange.
Under a particular ETF umbrella, the money is invested in various stocks which fit the objective of that particular fund. The ETF is then divided into various units and is bought or sold through a registered broker via the stock exchange. They are and can be traded like any other share on the stock market.
As the shares listed on the stock exchange are part of these ETFs, so any movement in the prices of these shares has a direct impact on the NAV (Net Asset Value). An investor can buy as many units as one wishes to without any restrictions from the exchange.
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To put it in simple words, ETFs are funds that track indexes like Nifty50, Sensex, etc. And when they invest in these ETFs, we are directly investing our interest in the movement of these underlying assets.
Therefore, ETF combines the range of stock in a diversified portfolio, and it is as simple as trading any stock in the stock market”
How do we earn using an Exchange-Traded Fund?
Two are two modes of earning via an ETF:
– Income in the form of Dividends
– Buying or selling in the secondary market like any other shares and gaining from it
Why should we invest in an ETF?
Now, having understood the technical aspect of an ETF, it is important for us to understand whether it makes sense to invest in an ETF. Let us discuss that:
Firstly, Investing in an ETF is certainly very easy and convenient. It can be traded just like any other share in the stock market. And also the very fact that ETFs are listed on the stock exchange, makes it even more lucrative to invest in. And that makes it also a very transparent instrument to trade in as the movement on the prices can be seen on an ongoing basis.
Secondly, unlike in other mutual funds, ETFs don’t attract any expense cost. So, if one is unsure about investing in shares of any particular stock, then one can choose to invest in sector-specific ETFs also.
How is Investing in an ETF different from investing in Mutual funds?
The basic premise of both ETF and Mutual Fund is the same. In both the forms of investment tools, the fund comprises a pool of shares and other assets and then the money is invested in them by the interested parties.
“A Mutual Fund is a collective investment that pools together the money of a large number of investors to purchase a number of securities like stocks, bonds, etc.”
However, the following are the most important point of difference between ETF and Mutual Fund:
- In Mutual Funds, you can invest only during specific times of the day (mostly after the close of the trading activity for the day), whereas in an ETF we can invest any time during the day.
- Price fluctuations happen throughout the day while trading ETFs, but in the case of Mutual funds, the price fluctuations happen only at the close of the market for the day.
- While trading an ETF, the cost incurred is in the form of brokerage from the broker firm but while trading Mutual funds, the cost incurred is in the form of commission (depends on expense ratio).
- The Mutual funds are actively managed by the fund manager and the idea is to beat the returns given by the market. But ETFs are passively managed as they track more of the performance of the index and they can be bought or sold just like any other shares in the market.
- While trading ETF, there is generally an additional cost involved and which is the bid-ask spread. And in the case of Mutual Fund, there is no additional cost of buying or selling the units.
- There is no penalty involved while buying or selling the ETF, but generally, mutual funds levy a penalty if we want to withdraw money before the stipulated time. Eg: some mutual funds levy a penalty if we withdraw money within 90 days after the initiation of investment.
The ETF has made a late entry into the world of investment, but it has been worth the wait. It has most of the features which a regular mutual fund has, but also gives the additional advantage of being able to be traded anytime during the day (unlike mutual or index funds). And with the growth of Mutual Fund as an investment incentive, the future looks very bright for this asset class.
That’s all for this post. We hope you have learned something new from our article on Exchange-Traded Fund. Let us know your views in the comment section below. Happy Investing and Trading!
Hitesh Singhi is an active derivative trader with over +10 years of experience of trading in Futures and Options in Indian Equity market and International energy products like Brent Crude, WTI Crude, RBOB, Gasoline etc. He has traded on BSE, NSE, ICE Exchange & NYMEX Exchange. By qualification, Hitesh has a graduate degree in Business Management and an MBA in Finance. Connect with Hitesh over Twitter here!