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Exchange Traded Funds (ETFs): What are ETFs and How they Work?

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What is an ETF?

Exchange-traded funds, commonly known as ETFs, are a collection of various securities such as bonds, shares, money market instruments, etc., that often track an underlying asset. Simply put, ETFs are a mashup of different investment avenues. They offer the best attributes of two popular financial assets – mutual funds and stocks.

ETF funds are somewhat similar to mutual funds in terms of their structure, regulation, and management. Additionally, just like mutual funds, they are a pooled investment vehicle that offers diversified investment into various asset classes like stocks, commodities, bonds, currencies, options, or a blend of these. Moreover, they can even be traded like stocks on the stock exchanges.

To understand this better, let’s comprehend the difference between open-ended and close-ended mutual funds.

Open-Ended vs. Close-Ended Mutual Funds

Traditional open-ended mutual funds can be bought or sold at any time from the fund company itself. However, close-ended mutual funds offer a fixed number of shares during the initial public offering (IPO), after which shares can be only bought from or sold to other shareholders in the open market.

One key difference: with open-ended funds, your counterparty is always the fund company itself. They will trade the securities at their Net Asset Value (NAV) at the end of the day. If you buy them after the markets have opened, you get the fund’s closing price for that day. If you buy them after the markets have closed, you are offered the fund’s closing price for the next business day.

On the other hand, with close-ended funds and exchange-traded funds, your counterparty isn’t usually the fund company itself. They are other shareholders who trade all day long, either directly or over stock exchanges. Hence, you can trade these funds at a price suitable to you.

ETFs and Close-Ended Funds

ETFs and close-ended funds are like close cousins because both financial products can be bought or sold over the stock exchanges. However, unlike close-ended funds, an exchange-traded fund is not actively managed. Instead, the securities in an ETF fund simply form a basket of investments intended to replicate an index as closely as possible. You can think of ETFs as close-ended index funds that are traded over exchanges.

Types of Exchange Traded Funds (ETFs)

There are several ETFs available to suit the demands of almost all investors. Following are some types of ETFs available to an individual:

1. Bond ETFs

These are typical ETFs designed to provide exposure to different types of bonds. Investing in bonds is a good way to mitigate the ups and downs of investing and diversifying a portfolio.

2. Currency ETFs:

These securities allow an investor to participate in currency market transactions without purchasing a specific currency. The motive of such investments is to track and benefit from the price fluctuations of a particular currency or a basket of currencies.

3. Inverse ETFs:

Such funds are designed to return the opposite of what is offered by the underlying market index. With these funds, share prices move in the opposite direction of the inverse ETFs’ share.

4. Liquid ETFs:

These funds try to minimize price risks and enhance returns by investing in a basket of short-term government securities, such as money and money market instruments with short maturities, while simultaneously attempting to maintain liquidity.

5. Gold ETFs:

Such securities offer investors the path to hold claims in the bullion market without making it necessary to purchase physical gold. You could also purchase ETFs that focus on precious metals in general.

6. Index ETFs:

Index funds track the performance of their underlying index. They are further subdivided into replication and representative ETFs. Index funds that invest entirely in the securities underlying the index are called replication ETFs. On the contrary, representative ETFs are those that invest a majority of their fund corpus in representative samples and the remaining in other securities such as futures, options, etc.

Advantages of Exchange Traded Funds (ETFs)

1. Liquidity:

ETFs can be sold throughout the day over stock exchanges, though some funds are more frequently traded than others. The more regularly a fund is traded, the easier it is to find a willing seller or buyer.

2. Lower cost:

ETFs have much lower expense ratios than traditional mutual funds. This is because ETF shareholders are not mandated to pay for the team of managers, analysts, and brokers to trade funds on their behalf or manage the fund’s inflows and outflows.

3. Transparency:

Unlike mutual funds that are only instructed to disclose their holdings quarterly, ETFs disclose the fund’s holdings and its NAV daily for open-ended schemes and close-ended schemes.

4. Diversification:

ETFs allow investors to diversify their portfolio across horizontals such as industries, sectors, styles, or countries. ETFs are also traded on virtually every major asset class, currency, and commodity in the world.

Uses of ETFs

ETFs can prove quite useful to those investors who demand focused exposure to a specific industry, asset class, region, or currency at a reasonable cost. Such investors do not have to worry about researching specific industries. What’s more, thanks to their low operational expenses, they are also suitable as long-term holdings for ‘buy & hold’ investors.

Additionally, they are useful to those who are looking forward to the asset allocation approach to investing. It is possible to find an exchange-traded fund that focuses on asset classes and also has a very low correlation coefficient with the rest of your portfolio. In other words, if your portfolio ‘zigs,’ the ETFs you are seeking tends to ‘zag.’ Ideally, this results in less volatility for your portfolio.

ETFs are one of the fastest-growing financial products in history. Now that you are armed with the basics of exchange-traded funds in India, you can make your mind and decide whether they make sense for your portfolio.