ETFs 101: A Beginner’s Guide to ETF Investing
Exchange-Traded Funds (ETF) is an investment fund traded on stock exchanges, similar to individual stocks. They have become increasingly popular among investors due to their low fees, diversification, and transparency. ETFs offer an easy way for investors to access a diversified portfolio of stocks, bonds, or commodities, without the hassle of managing individual assets.
This blog aims to provide a comprehensive guide for beginners to understand ETFs and their benefits. We will discuss what ETFs are, their evolution over time, the benefits they offer, how to invest in them, and factors to consider before investing.
What is an ETF?
An ETF is a tradable instrument that tracks an index like Nifty/Sensex, a commodity like gold, bonds, or a basket of assets. The first ETF in India was created in 2001 when Benchmark Mutual Fund launched the Nifty ETF Fund with a defined objective to track the performance of the Nifty-50 index. Since then, the ETF industry in India has witnessed slow but steady growth.
ETFs are very similar to mutual funds, main difference being the former is listed on exchanges & trades just like stocks and can be bought or sold via your brokerage account anytime during market trading hours. ETFs are also typically more tax-efficient than mutual funds, as they have lower capital gains distributions.
Another key difference between ETFs and individual stocks is that ETFs expose investors to a diversified portfolio of assets. When you invest in an ETF, you are buying a small piece of a larger portfolio of stocks, bonds, or commodities, which helps to minimize your investment risk.
Different types of ETFs:
- Index ETFs are the most common type of ETF, and they track a specific index such as the S&P 500 or the Nasdaq. These ETFs offer exposure to a broad range of stocks and are a good option for investors seeking diversification.
- Sector ETFs focus on specific sectors of the economy, such as technology, healthcare, or energy. If you believe a particular sector is poised for growth, these ETFs can be a good option.
- Bond ETFs track a basket of bonds, such as Treasury bonds or corporate bonds. These ETFs can be a good option for investors seeking income and capital preservation.
- Commodity ETFs track the price of commodities such as gold, silver, or oil. These ETFs can be a good option if you want to invest in commodities but don’t want to buy physical commodities.
- Small cap ETFs are a type of ETF that invests in companies with smaller market capitalizations. These companies are often younger and have a higher growth potential than larger, more established companies. Small-cap ETFs can be a good way for portfolio diversification and capture the potential for high returns.
Some of the most popular ETFs include SPDR S&P 500 ETF Trust (SPY), Invesco QQQ Trust (QQQ), and iShares MSCI EAFE ETF (EFA).
How do ETFs work?
Exchange-traded funds are a type of mutual fund that tracks and follows a specific index or asset. This could be an index like Nifty 50 or an asset like Gold ETF. The ETF will closely match the constituents of an index or the price of an asset. Your investments in an ETF will move in the same trajectory as the asset or index it tracks.
ETFs trade on stock exchanges and can be bought and sold during market hours, the same way we would buy and sell stocks of listed companies. As mentioned above, an ETF tracks an index. So, if you invest in a Nifty ETF, you will generate the exact same returns as the Nifty. If Nifty goes up by 10% in a year, your Nifty ETF will also give you 10% returns for the same period. Because ETFs don’t require any active portfolio management, they are low-cost instruments.
Advantages of investing in ETFs?
It would be expensive for an investor to buy all the stocks of an index or impossible for him to buy a certain quantity of a commodity for a low amount, say ₹1,000. An ETF solves this problem by giving the investor access to many stocks across various industries or allowing the investor to invest in a small quantity of the commodity at a reasonable price.
ETFs usually tend to have low expense ratios since they track an underlying index or commodity.
Below are a few advantages of investing in ETFs:
- Low cost of investing: Because actively-managed mutual funds require the expertise of a fund manager and research team, these funds come with high management fees. ETFs, on the other hand, have little to no management fees.
- Real-time investments: ETFs trade on an exchange, which is why they can be bought and redeemed at their real-time per unit price. The flexibility to invest or redeem during the day allows the investor to take advantage of sudden movements in the markets.
- Returns that can be relied upon: Actively-managed funds have the mandate to beat their benchmark index. This also puts them at risk of losing money in lieu of earning higher returns. An ETF tracks an index, which is why its performance will be in line with the index. If you believe that the Nifty is going to rise in the coming years, you can simply invest in a Nifty ETF and participate in its growth.
Disadvantages of investing in an ETF
And while there are significant advantages of this instrument, let’s talk about a few disadvantages of ETFs:
- ETFs that track an index suffer from something called tracking error. It is the difference between the index return and the fund return. Note, though, this is also applicable to any passive mutual fund which is tracking an index
- In rare times of poor liquidity, the bid/ask spread (i.e. the buying/selling costs) can be high, leading to higher costs.
- In India, placing SIPs into ETFs isn’t as convenient as they are in mutual funds.
- Lastly, there aren’t many varieties of ETFs in India yet – current offerings are limited to large & midcap index trackers, gold, and debt. However, this will change as its popularity & penetration increase – today, the developed markets have all kinds of niche ETFs, but they started off in a similar vanilla fashion.
How to invest in ETFs?
- Before you invest in ETFs, it’s important to determine your investment goals and risk tolerance.
- Once you’ve determined your investment goals and risk tolerance, it’s time to select the right ETFs for your portfolio. There are many different types of ETFs, including index ETFs, sector ETFs, bond ETFs, and commodity ETFs.
- Select a brokerage platform to invest in ETFs. You’ll need to open an account with the brokerage platform and fund your account with cash or securities.
- You can now buy ETFs through your brokerage account by entering the ticker symbol and the number of shares you want to purchase.
- Investing in ETFs is a long-term strategy. It’s essential to monitor your investments regularly and rebalance your portfolio if necessary. Rebalancing involves buying or selling assets to maintain your desired asset allocation.
Here are some tips for selecting the right ETF as per your investment goals
- Determine your asset allocation based on your risk tolerance and investment goals.
- Look for low expense ratios to minimize your costs.
- Choose ETFs with high liquidity and narrow bid-ask spreads.
- Check the ETF’s holdings to ensure they align with your investment goals and risk tolerance.
- Evaluate the ETF’s performance over time.
Investing in ETFs via smallcase
smallcase offers 500+ readymade stock/ETF baskets made by SEBI-registered professionals. Investing in ETFs using smallcase is an easy way to diversify your investment portfolio.
To invest in ETFs via smallcase, first login on the website or the app with your phone number. Then, go to discover and in the search bar, type ‘ETF’. You’ll now see an array of ETF smallcases based on various themes. You can pick the one that fits your investment criteria and invest in it. And…you’re done!
ETFs have taken over the world, with AuM in such funds surpassing those in traditional mutual funds in many countries. The low-cost & instant liquidity provided by ETFs have appealed to investors globally.
If you are a long-term investor with SIPs every month & no intention of redeeming in the near future, then ETFs can be an ideal option.