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What Are ETFs and How Do They Work?


Exchange Traded Funds are easy to understand. It is a fund that represents a basket of securities, like any other fund. But it can be bought or sold on the markets like a stock, unlike a mutual fund. An ETF will track all the price movements of the securities it represents, for example, the SBI Nifty 50 ETF tracks…you guessed right, the Nifty 50 index, which in turn tracks the top 50 stocks on NSE. 

How Do ETFs Work:(and how they are different from mutual funds)

ETFs are composed of a basket of assets, such as stocks, bonds, or commodities, and they are managed by professional asset managers. ETFs are good at tracking indexes or sectors of the market. ETFs are a good way to diversify your portfolio. 

ETFs are built by buying a basket of shares based on sectors, indexes, or other categorizations and then selling units of these shares on the markets. The shares of an ETF are held in a trust and generally do not change unless this is an actively managed ETF or the composition of the sector or index it tracks changes. The units of the ETF are fractional ownership of the different shares held in this trust. ETF, as the name suggests, are bought and sold directly on exchanges directly. ETFs are rebalanced based on the index/sector annually and there is no need for the investor to intervene in the process since this is done transparently. 

Mutual funds and index funds, which are a type of mutual fund, are different since they can be bought off an exchange or from the mutual fund company. The funds that are invested are then channelled to the stocks that the mutual fund subscribes to.  

Mutual fund NAV is calculated by dividing the total net assets by the total number of units issued. As against this, ETF prices change based on the principles of demand and supply every minute. So an ETF is more like a stock when it comes to price movement. 

Difference Between ETF And Mutual/Index Fund

Mutual funds have different flavours, like index funds and sectoral mutual funds. At first sight, ETFs might look similar to mutual funds since the underlying assets it invests in are the same, but there are a few important differences between the two. 

  1. Structure: ETFs are traded on exchanges, just like stocks, whereas index funds are not. This means that ETFs can be bought and sold throughout the day, while index fund trades are only executed once a day at the close of the market.
  2. Fees: ETFs generally have lower fees than index funds because they do not require the same level of active management. ETFs are passively managed, meaning they simply track the performance of an index, whereas index funds are actively managed, meaning a team of professionals selects the individual stocks that make up the fund.
  3. Diversification: Both ETFs and index funds provide diversification by holding a basket of stocks that represent a particular market or sector. However, ETFs may offer more diversification within that basket because they can hold a wider range of securities, such as bonds, commodities, and real estate.
  4. Tax efficiency: ETFs are generally more tax-efficient than index funds because they do not have to sell securities as often to meet investor redemptions. This can result in fewer capital gains taxes for ETF investors.
  5. ETFs do not issue new units when you buy them on the secondary market, whereas mutual funds issue new units when you invest in them
  6. The price movement of an ETF is more like a stock and instantaneous, unlike a mutual fund whose NAV is calculated at the end of each day.

Advantages Of ETFs:

  1. ETFs offer investors the convenience and diversification of a mutual fund, but with the flexibility and liquidity of a stock.
  2. One of the main advantages of ETFs is their low costs. Because they are passively managed, ETF is typically have lower fees than actively managed mutual funds. 
  3. In addition, ETF offer investors the opportunity to buy and sell shares throughout the trading day, unlike mutual funds, which only trade at the end of the day.
  4. ETF can be a good choice for investors looking to diversify their portfolios and gain exposure to a specific asset class or market.

Disadvantages Of ETFs:

  1. No customizations are possible in most ETFs. The basket of stocks that an ETF subscribes to remains unchanged based on index or sector. 
  2. Tracking Error does exist between the actual index/sector and the ETF performance and this can cause a difference in the returns of the benchmark and ETF. 
  3. Traders actively trade ETFs making these instruments volatile in the short term.

Conclusion :

ETFs are a great way to have diversified (across stocks) yet focused (around sectors and indices) investments. They are flexible, generally offer good liquidity, can be traded around the clock during market hours, and have lower fees than most mutual funds. ETFs are wonderful investment instruments.