What is an ETF? A Comprehensive Overview

Personal Finance is something that everyone needs in their life to grow their savings and investments. In this article, we will understand “What is an ETF?” and try to clear all the basic doubts about-

• ETF Meaning
• How does ETF work?
• How ETF is different from mutual funds?
• How to buy and sell ETF? etc.

Stay with us through this blog, and we assure you that it will be the only one you’ll ever need to fully understand everything about ETF and to answer your all doubts regarding ETFs.

For people who are interested in investing, it is very important to understand how to invest your hard-earned money wisely to achieve your future goals. People typically invest in mutual funds, and those more interested in the stock market might choose to invest directly in company stocks after doing a self-fundamental analysis. However, nowadays, there’s a new buzzword added in this space: ETFs (Exchange Traded Funds).

What is an ETF (Exchange Traded Funds)?

Before diving into the core concepts of ETFs and answering the question What is ETF?, let’s first take a glimpse at the history of ETFs. ETF was first introduced to us in the 1990s in Canada and right after 3 years, SPDR(S&P 500 Trust ETF) came into existence in the USA which is even more popular to date. ETFs were introduced after Index funds.

ETF stands for Exchange-Traded Funds. As the name implies it is a type of fund that can be traded on the stock exchange. For an analogy think like a stock getting married to an Index mutual fund and their child is an ETF.

Different Types of ETF

There are two types of ETFs –

Active ETFs

These are ETFs with a Fund Manager & Team that decides on investment and thus they are a bit expensive.

Passive ETFs

Most of the ETFs are passive as they blindly track the index and don’t have a manager or team thus their expense ratio is very less like index funds.

What characteristics of stock an ETF has?

• ETFs are traded like a stock on the stock exchange.
• ETF’s price keeps on fluctuating like a stock every second.
• When we buy an ETF it directly reflects in our Demat Account like a stock.

What characteristics of Mutual Funds an ETF has?

• Just like an index mutual fund tracks an index, an index ETF also tracks an index. In both cases, you are investing in a collection of companies that make up the index.
• It has a bit lower expense ratio. Basically, the maintenance charge of the fund you pay when you take an exit.

ETF vs Mutual Fund / ETF vs Index Fund

So far you might have got an idea “What an ETF is”. Now let’s understand more about How ETF is different from any Mutual Fund. When we are trying to invest our hard-earned money, we always try to figure out the answer of below questions-

• What are the advantages of exchange-traded funds (ETF) over Mutual Funds?
• What are the advantages of exchange-traded funds (ETF) over Stocks?

A small and precise answer to above questions-

Trading on Exchange

ETFs are traded on exchange just like stocks but Mutual funds are not. That means you can sell these funds at any time to any buyer at a particular price you set and vice-versa. That’s why to invest in ETFs you need a Demat account whereas to invest in Mutual Funds or Index mutual funds it is not necessary at all since you are not buying or selling anything directly to anyone.

Funds handled by AMC

Also, In Mutual Funds, all your transaction with the fund is handled by AMC(Asset Management Company) so you need not worry about a buyer for your units AMC has millions in liquid so they can settle your request by cutting their maintenance charge(Expense Ratio).

Buyer’s Issue

However, if you have invested in ETFs that don’t have enough buyers you might struggle to sell it unless you get a buyer for it at the price at which you want to sell just like a stock.

Hope now you have a clear understanding of ETFs and how these are different from Mutual funds or Index Mutual Funds. Now, Let’s jump to another step.

What to consider before investing in an ETF?

When we purchase a stock, we evaluate the company’s fundamentals. Similarly, before buying an ETF, we should check its AUM (Assets Under Management) which should be at least greater than 10 million to avoid a situation where we can’t sell the ETF when we want to, this concept is popularly known as liquidity. So basically you need to select an ETF that has high liquidity to make sure you don’t get stuck while doing an exit else you have to sell at a lower price from your current price to close your trade which nobody wants right?

Now coming to the question of How to choose the right ETF to invest? OR What are some of the best ETFs to look for in the stock market?

There are broadly 4 parameters based on which you can choose the best ETF.

Category

There are four major categories-

• Equity ETF
• Gold ETF
• ETF with International Exposure
• Debt ETF

Equity ETF

In Equity ETFs, all the holdings will be in Equity only.

Gold ETF

In Gold ETFs, all the holdings will be in Gold only.

ETF with International Exposure

In ETFs with international Exposure, the holdings will be in foreign markets.

Debt ETF

In Debt ETFs, it will have holdings in bonds and securities.

Liquidity

This we have already discussed above in what sort of ETFs should you invest in. So, ETFs with large volume are considered as safe to trade.

ETF Expense Ratio

It can vary depending on the type of ETF i.e. Active ETFs or Passive ETFs. However, it is one should look for an ETF which has a minimal expense ratio.

Check Tracking Error

ETFs are supposed to track specific indices, so they should ideally match the returns of the index they are tracking. However, this is not always the case. Some funds retain a portion of their assets for maintenance, which can lead to higher tracking errors in actively managed ETFs compared to passive ETFs. The expense ratio and tracking error are directly correlated.

Based on these four parameters, you can make an informed decision about which ETF to trade. The choice of category is subjective and should be based on your knowledge.

For instance, if you have a good understanding of equities, you might choose an Equity ETF. Within this category, you can find various subcategories or sectors to invest in, such as the top 20 companies on an index, the EV sector, the IT sector, the energy sector, etc. This is a broad topic in itself.

If you have come so far you might have understood ETFs and how to choose the best ETF for you.

Benefits of ETF Investing

Now let’s talk about the Benefits of ETF investing–

Easy to trade and use

The very first benefit is it is super easy to trade as you can buy and sell anytime when the market is open, unlike mutual funds which that are traded at the end of the day.

Lesser Risk

When you compare it with stock buying it has very low risk as it is a fund and it holds stock from multiple companies so your money is invested in multiple companies, unlike stock buying.

Trading Transactions

Since it is traded like a stock you can place a limit order or stop loss.

Tax efficient

ETFs are more tax-efficient as compared to active mutual funds.

After all over ETF knowledge, we have come to our final steps and those are-

• How do I start trading ETFs?
• How to buy an ETF?

The answer is really simple, you just need a Demat account and follow below steps-

• Open your broking application.
• Search for ETF with category. For example – Gold ETF
• Select the ETF from which you want to buy.
• Select the quantity and transfer the money. That’s it.

Conclusion

We understood ETFs from the basics and then we tried to understand the core difference between ETFs and Mutual funds/Index Mutual Funds. Later we understood how we can select the right ETF and the benefits of ETF investing. Last but not least we understood how we can buy an ETF through our application.