Exchange Traded Funds are open ended schemes that invest a majority of their investible corpus in the underlying index or benchmark. While other mutual funds try to outperform their underlying benchmark, exchange traded funds do not try to generate better returns than their benchmark. Instead, they try to replicate the performance of their underlying benchmark. Returns from exchange traded funds are subject to tracking errors. Also referred to as ETFs, exchange traded funds are ideal for investors who want to understand how the equity markets function and are looking forward to starting trading in stocks soon. That’s because exchange traded funds are listed at the stock exchange just like any other company stock.

Types of Exchange Traded Funds

Equity oriented exchange traded funds are open ended schemes that only invest in the company stocks belonging to a particular index like the NIFTY 50 or SENSEX 30.

Debt oriented exchange traded funds are schemes that invest in fixed income securities and debt related money market instruments.

Gold exchange traded funds are a commodity exchange traded fund that tries to generate returns by tracking the price of domestic gold and by investing in physical gold related assets.

International exchange traded funds are mutual funds that invest in equity and equity related instruments of companies that are publicly listed outside India.

How does an exchange traded fund work?

Some may not be aware but exchange traded funds are a unique investment tool that shares similar traits of mutual funds as well as stocks. For example, they have professional fund management, have an expense ratio like mutual funds, and invest in a diversified portfolio of securities. On the other hand, they are available for trading at their current market price. ETFs are listed at almost every stock exchange and investors can buy or sell their ETF units just like they trade in company stocks.

Investors need a demat account to hold their ETF units. Exchange traded funds offer higher liquidity than other mutual funds as one can enter or exit their ETF investments end number of times throughout the day at the fund’s changing market price. The fund manager may reshuffle the portfolio of an exchange traded fund but doesn’t actively buy or sell securities to generate returns. ETFs are designed to mimic the performance of their underlying benchmark and generate capital appreciation. 

Why do several investors consider Exchange Traded Funds?

As mentioned earlier, exchange traded funds invest in a diversified portfolio of securities. This is better than investing in stocks as there is a huge concentration risk. If the company whose stocks you bought is unable to generate revenue, it will affect its stock price and in turn, affect your stock investments. In the case of exchange traded funds, since they invest in a basket of stocks, even if one stock underperforms investments in other stocks can even out the losses.

Since exchange traded funds follow a passive investment strategy, they have a relatively low expense ratio as compared to other mutual funds that are actively managed. A low expense can maximize one’s capital gains in the long run as opposed to schemes that have a high expense ratio.

Investors do not have to wait for the NAV of the ETF to be concluded at the end of the day to trade in its units. Since ETFs are tradable security that can be bought or sold throughout the business day, unlike mutual funds whose NAV is determined at the end of the day. These funds are ideal for investors who do not want their portfolio to have any decisions based on human biases.