Exchange Traded Funds (ETF) basics and myths around it
Exchange Traded Funds (ETFs) are an investment fund that tracks the performance of a specific index. Just like stocks, one can trade ETFs on a stock exchange. An ETF is structured in the same manner as the unit creation of a Mutual Fund scheme. The units can be bought and sold very conveniently and directly on any exchange trading platforms during the market hours daily.
Exchange Traded Funds give you the best of both worlds
Like Mutual Funds (managed), ETFs are a basket of stocks, bonds or other assets. But, overall there are key differences between direct stocks and ETFs. ETFs combine certain key features of stocks and Mutual Funds (managed).
- Diversified: ETFs are more diverse than investing in individual stocks. Instead of buying a handful of individual stocks, investing in an ETF would give you instant exposure to a multitude of stocks.
- Market access: For investors who would like to invest in difficult-to-access markets such as emerging markets, it now becomes straight forward by investing into an ETF.
- Indexing: Unlike a Mutual Fund (managed), an ETF does not aim to beat the index. The objective is to match its performance.
- Lower costs: ETFs generally track the index. It usually costs much lower compared to Mutual Fund (managed).
- Liquidity and convenience: ETFs give you flexibility in allowing you to enter and exit at any time during market hours.
Risks associated with ETFs
All investments come with risk. ETFs are no exception. Before getting into the risks associated with ETFs, let’s simply try to understand what risk(s) can do to an investment. It is the chance of adversely affecting the value of investment. Before taking any investment decisions, it’s important for you fully understand the risks involved.
- Capital risk:All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.
- Liquidity risk: Liquidity is the facility to convert an investment into cash, with no negative impact in its value. Low liquidity of an ETF s can lead to higher trading costs or difficulty in buying or selling the ETF. As Financial Advisor in Kolkata, we assess liquidity by looking at statistics such as:
- Average bid/ask spreads: It’s the difference between the buy and sell price of the ETF. In general, the narrower the spread, the more liquid will be an ETF.
- Average trading volume: In general, the higher the volume, the more liquid is an ETF.
- Whether the ETF is trading close to its net asset value: It’s an indication of the fair value of each ETF. The closer it is, the more liquid the ETF is.
- Taxation risks:International taxes will impact your return on international ETFs. Proper research is necessary to assess how much tax implication may arise.
As your SEBI Registered Investment Adviser in Kolkata, we cannot eliminate investment risk(s). Through certain goal-based investment strategies we make an attempt to reduce the overall investment portfolio risk(s).
A simple technical comparison between Exchange Traded Funds, Stocks and Mutual Funds
Basic idea about an ETF
Technical comparison between Exchange Traded Funds, Stocks and Mutual Funds
Gaining popularity in India
Association of Mutual Funds in India (AMFI) data reflects how rapidly ETF market share has been increasing.
AMFI Data on ETF Market Share
Peculiar myths create misunderstanding among new investors. We have made an attempt to bust common myths around ETFs and highlight what features they possess in reality.
Myth 1: ETFs are volatile because they are traded throughout the day.
Reality: ETF prices are transparent. This attribute doesn’t make them more volatile.
The price of an ETF reflects the changing value of its underlying securities.
The price of Mutual Funds (managed) reflects the value of its underlying securities. It is fixed once a day and only after the market closes. ETF prices change throughout the day in real time. This doesn’t mean that ETFs are more volatile – their price changes are just more visible.
Myth 2: ETFs are inherently risky.
Reality: Risk is driven by the assets you’re investing in, not necessarily the vehicle used to access the assets.
Just like Mutual Funds (managed), the risks of an ETF are based on its underlying holdings. So, if a Mutual Fund (index) and an ETF hold exactly similar stocks or bonds, both will have similar risk(s).
Myth 3: ETFs only apply if you’re investing in a very specific piece of the market.
Reality: You can use ETFs for a wide range of exposures and outcomes.
We can take exposure in various asset classes and related categories via ETFs. They offer low-cost access to specific markets (e.g., a country or industry.
Whether it’s hard-to-access foreign markets, core portfolio construction or thematic schemes, there’s an ETF that are available in the market.
Myth 4: ETFs are just for day traders.
Reality: ETFs are effective investment tools for many categories of investors.
Because ETFs have the same trading flexibility as stocks, short-term traders can use ETFs to quickly move in and out of a position. But, as Certified Financial Planner in Kolkata, we see ETFs as cost-efficient way to build a long-term core portfolio. Although an ETF can be bought and sold like equity shares on an exchange, we believe that it should not be traded like one. Both Mutual Funds and Exchange Traded Funds can co-exist in an investment portfolio.
As Fee Only Financial Planner in Kolkata, we are of the opinion that ETFs are an innovative investment tool, which is slowly catching up with their global investing trends in India. With reducing liquidity issue, effective risk diversification, low expenses and simple trading system, ETFs have gained popularity in a very short period of time. As they pick up, ETF providers will definitely widen their level of assets, leading to more liquidity.
