What are ETFs?
ETF or Exchange traded funds are passive mutual fund schemes, which aim to mirror an individual market index like Sensex, CNX Nifty, BSE Sensex, Nifty 100, etc. ETFs invest in a basket of shares or stocks that mirrors the index the ETF intends to track. The weight of individual security in an ETF portfolio mirrors the weight of the security in the index. ETFs do not intend to beat their respective benchmark indexes; their aim is to mirror the index return.
Basic Terms of ETFs
There are some basic terms that you should understand before investing in ETFs, which are as follows:
1. Creation Unit
This is the minimum number of shares an ETF can issue or redeem. For example, if the creation unit size for an ETF is 50,000 shares, then you cannot buy or sell less than 50,000 shares of that ETF.
2. Authorized Participant
Also known as APs, these are the only market participants that can buy or sell ETF shares directly from the ETF. APs are typically large financial institutions, such as banks or broker-dealers.
3. Passive vs. active ETFs
As the name suggests, passive ETFs track a specific index, while active ETFs are managed by portfolio managers who actively trade the underlying securities to outperform a benchmark index.
4. Expense ratios
This is the annual fee that all ETFs charge shareholders to cover the costs of running the fund, such as management fees, administrative expenses, and other operational costs.
5. Dividends and DRIPs
Dividends are cash payments companies make to their shareholders, typically every quarter. DRIPs, or Dividend Reinvestment Plans, allow shareholders to reinvest their dividends into the ETF, often at a discounted rate.
Now that you know the basics of ETFs let’s look at how you can start investing in them.
How to Invest in ETFs?
To invest in ETF, first of all, you need to have a share trading account along with demat. If you do not have a trading and demat account, you can open the same with a stock-broker after fulfilling KYC requirements. There are 3 ways of investing in Exchange traded funds:-
- During the NFO period: You can subscribe for ETF units directly with the Asset Management Company (AMC) during the NFO period. During the NFO period, ETFs are usually issued at a par value or face value (usually Rs 10 per unit). At the end of the NFO subscription period, the AMC will allot units of the ETF to you just like any other mutual fund investment.
- After the NFO period in stock exchanges: ETFs are listed in stock exchanges and trade just like shares of listed companies. After the NFO period, you can buy ETF units on stock exchanges at market prices. The market price of an ETF can be higher or lower than the NAV of the ETF.
- After the NFO period with the AMC: You can buy ETF units at applicable mutual fund NAV if you are buying in lot sizes (minimum number of units) based on creation units as specified by the AMC in the Scheme Information Document (SID) of the ETF. The lot size of an ETF is usually much larger than the average investment ticket size of a retail investor of mutual funds.
How to Sell ETF Units?
There are two ways of selling ETF units:
- In the stock exchange: This is the most common option for selling your ETF units. When you sell ETF units in the stock exchanges, the transaction will take place on the basis of the market price and not the ETF NAV. When you are investing in ETFs, you should know that you need a buyer to sell your ETF units in the market (exchange). AMCs appoint market makers to ensure the liquidity of ETFs; the market makers will act as buyers if there are not sufficient buyers in the market. However, in extreme market conditions, if your ETF is illiquid (do not have a sufficient number of buyers), you may not be able to sell your ETF units on a particular day. Therefore, you should always look at the liquidity of the ETF when you are investing in them. ETFs with high average daily traded volumes are more liquid than ETFs with low average daily traded volumes. You will get daily traded volume data on the stock exchange websites.
- Redeem with the AMC: You can also redeem your ETF units directly with the mutual fund company if you are redeeming in lot sizes (minimum number of units) based on the creation units as specified in the SID of the ETF.
Benefits of Investing in ETFs
Mentioned below are the significant benefits of investing in ETFs:
ETFs are traded on stock exchanges and can be bought and sold through a broker, just like stocks. This makes them easily accessible to investors.
There are ETFs available for a variety of asset classes, including equities, bonds, commodities, etc. This allows investors to choose an ETF that best suits their investment goals.
- Low Cost
ETFs have lower expenses than traditional mutual funds. This is because they are passively managed and do not have high management fees.
ETFs offer more flexibility than traditional investments such as mutual funds. For example, investors can buy and sell ETFs anytime during the day. They can also invest in various strategies such as short selling and leverage investing.
ETFs are required to disclose their holdings daily. This makes them more transparent than traditional mutual funds, which only have to disclose their holdings once a quarter.
- Tax Efficiency
ETFs are generally more tax-efficient than traditional mutual funds. This is because they have lower turnover and can be sold at a loss to offset capital gains.
ETFs are highly liquid and can be easily bought and sold on the stock exchange. This makes them a good choice for investors who need to access their money quickly.
The Bottom Line
Exchange-traded funds offer a convenient way to invest in sectors or asset classes, and they can be bought and sold. Before investing in an ETF, research the underlying holdings to make sure it meets your investment objectives.