Exchange Traded Funds (ETF)

Trading in the stock market is a rather complex undertaking, one needs to look at different assets in different asset classes, understand their pros and cons and find a way to fit them into a portfolio that matches their needs. All this hard work often discourages people from investing in the stock market. This is where ETFs and mutual funds come in, in this article let's explore the world of ETFs.

An ETF is a security that tracks an index, sector, economy, commodity or any other type of asset but can be purchased and sold on the stock exchange like a normal stock. A few well known Indian ETFs are Nippon India ETF Nifty BeES, Nippon India ETF Bank BeES and Motilal Oswal Midcap 100 that track Nifty 50, Nifty Bank and Nifty Midcap 100 respectively.

Each ETF has multiple underlying assets that are usually determined by the index it is tracking. ETFs can only be created by specialized institutional investors called authorized participants (AP). When the AP wants to issue more shares of the ETF it has to buy the underlying assets of the index it is tracking and then exchange them to the ETF for new ETF shares at an equal value. In turn, the AP sells the ETF shares in the market for a profit. On the other hand an AP can also buy the shares of an ETF and sell its components in the stock exchange thus reducing the number of ETF shares in the market.

There are two different types of ETFs based on management style namely actively managed, passively managed ETFs. The portfolio managers of actively managed ETFs are more involved in buying and selling shares of companies and changing the holdings within the fund. This translates to a higher expense ratio than passively managed funds and higher returns.

Since the ETFs have multiple assets within them they are a popular choice for Risk management through diversification. ETFs are used by investors to test the waters of a new economy or industry as they have low expense ratio (Annual maintenance charge to cover management expenses) and fewer broker commissions making them a cheaper investment and several ETFs focus on particular industries or economies exclusively.

At this point an ETF might seem superior to normal equity, however ETFs do have their own shortcomings. Higher fees of actively managed funds, single industry focus of several ETFs, lack of liquidity are just a few. Be it an ETF, a bond or a stock at the end of the day every investor has to weigh in the pros and cons and calculate the risk to reward of an asset before plunging right into it.