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Exchange Traded Funds (ETF)
What
are Exchange Traded Funds (ETFs)?
An ETF is a basket
of stocks that reflects the composition of an index, like S&P CNX Nifty, BSE
Sensex or the banking index. An ETF’s trading value is based on the net asset
value of the underlying stocks that it represents. It is similar to a mutual
fund that you can buy and sell in real-time at a price that changes during the
trading session. ETFs are essentially index funds that are listed and traded on
exchanges like stocks. They enable investors to gain broad exposure to entire
stock markets in different countries and specific sectors with relative ease, on
a real-time basis and at a lower cost than many other forms of investing.
What are the type of ETFs?
The two popular
ETFs in India are index ETFs and commodity ETFs. Most ETFs in India are index
funds that hold securities and attempt to replicate the performance of a stock
market index. Nifty Bees, Junior Bees, Gold Bees, Bank Bees and Hang Sang Bees
are some of the ETFs traded in India. Among the commodity ETFs, gold ETFs are
actively traded in India.
What are the advantages and disadvantages of using ETFs?
There are several benefits in investing in ETFs. They can be easily bought
and sold like stocks during trading hours using your demat account with no
additional paperwork. They have lower expense ratio and the minimum investment
is of one unit. However, unlike mutual funds that do not need a demat account,
for buying and selling ETFs you need a trading account. Also since ETFs, like
stocks, are bought through a broker, every time you trade you also end up paying
brokerage for your transaction. However, ETFs allow investors to take the
benefit of intra-day movements in the market, which is not possible with
open-ended funds.
Take the example of a gold ETF. Buying physical gold and storing it involve
tedious processes. You will have to pay a mark up to the jeweller and then spend
some more get a bank locker. On the other hand, buying, selling and storing gold
in electronic form is more convenient and price-effective. As ETFs are listed on
the exchanges, distribution and other operational expenses are significantly
lower.
How are ETFs used?
Asset allocation: For individuals it could be difficult to manage asset
allocation given the cost involved. ETFs provide investors with exposure to
broad segments of the equity markets. They enable investors to build customised
investment portfolios in line with their risk taking ability and time horizon.
Ride the market rally: Many times, investors need time to make investment
decisions, like buying a particular stock, but do not want to miss out on the
opportunity in the stock markets. At such times they can park their funds in
ETFs. Because ETFs are liquid, investors can participate in the market rally
while deciding where to invest the funds for the longer-term, thus avoiding
potential opportunity costs.
Hedging Risks: ETF’s can be used as hedging vehicle because they can be borrowed
and sold short. The smaller denominations in which ETFs trade relative to most
derivative contracts provide a more accurate risk exposure match, particularly
for small investment portfolios
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