What Are Exchange Traded Funds (ETFs)? Learn More About This Investment Instrument

Exchange Traded Funds are a type of investment instrument that are quite similar to mutual funds in many aspects.

<div class="paragraphs"><p>Source: Yiorgos Ntrahas on Unsplash</p></div>
Source: Yiorgos Ntrahas on Unsplash

Exchange Traded Funds (ETFs) Explained

In simple terms, an exchange-traded fund or an ETF is something that is similar to a mutual fund, that contains a combination of securities and can be traded on the stock market. Similar to mutual funds, exchange-traded funds combine the investments of a large number of people to purchase tradable assets such as shares, debt securities, bonds, etc. Most of the exchange-traded funds that operate on the stock market are also registered with the Securities and Exchange Board of India (SEBI). Generally, ETFs invest and track the stocks/securities of a particular index, industrial sector or commodity type, making them friendly for beginner investors. Unlike mutual funds, ETFs can be sold and purchased on the stock market just as easily as regular stocks.

How Do Exchange Traded Funds (ETFs) Work?

As mentioned above, ETFs work somewhat similarly to mutual funds as ETFs contain a combination of securities which are generally picked from an index, a particular sector or a commodity. ETFs can be traded on the stock market similarly to stocks through the creation unit blocks. Most ETF funds are listed on all major stock exchanges across the country and can be traded freely during trading hours. The prices of ETFs change depending upon the change in prices of the underlying securities that are present in any particular ETF. If the prices of any assets under the ETF rise, the price of the ETF also rises, and vice versa. The dividends received by ETF shareholders also depend upon the performance of the companies that are under any singe ETF. ETFs can be managed actively or passively; actively managed ETFs are operated by a professional portfolio manager and the securities are carefully selected. On other hand, passive ETFs only contain those securities that are part of any particular index, commodity, or industry.

Types of Exchange Traded Funds

ETFs can be divided into the following categories: 

Equity ETFs: These are ETFs that generally invest into company stocks and other forms of company equity. 

Gold ETFs: These are ETFs that only invest into physical gold assets. Purchasing gold assets means you own the physical gold through paperwork. 

Debt ETFs: These are ETFs that generally invest only into debt securities like government securities and debentures. 

Currency EFTs: These are ETFs that mainly contain a combination of different nations' currencies and the value of the ETF goes up and down depending on the exchange rates of currencies that are in the ETF. 

Also Read: Bharat Bond ETF: Edelweiss Mutual Fund Launches Fourth Tranche

Some Pros And Cons Of ETFs

Some of the ‘Pros’ or advantages of ETFs are: 

  • Purchasing ETFs allows investors to inherently diversify their portfolio since ETFs are a combination of securities rather than single stocks. 

  • ETFs are cheaper than Mutual Funds since many different fees that are associated with mutual funds are not associated with ETFs. 

  • ETFs provide flexibility and liquidity since they can be sold at any time on the stock market. 

  • Passively managed ETFs are low-risk and beginner friendly. 

Some of the ‘Cons’ or disadvantages of ETFs are: 

  • Although cheaper than Mutual Funds, there are still some fees such as brokerage fees and fund manager’s commissions. 

  • Since ETFs are inherently linked to the stock market, any volatility in the stock market fluctuates their prices, so they are less secure than stable securities like government bonds. 

  • Since ETFs are primarily passively managed, they mostly invest in large highly rated companies. However, this means that ETFs can miss out on small companies that have huge margins of growth.