Equity investments can be enthralling. There is news about how HNIs booked profits by selling stocks of a certain company or if they have invested a certain percentage in an XYZ company. It motivates aspiring investors to commence the stock market investing journey. However, a lot of investors end up doing the rookie mistake of buying stocks that are peaking and then are left in a dilemma when the prices go down. What some investors do is that instead of directly investing their money in the stock market, they try to get a fair understanding of how the stock market works by investing in market linked mutual fund schemes like exchange traded funds.
Exchange traded funds(ETFs) are an excellent option for anyone who wishes to invest in equities but lacks the knowledge to do so. Equity markets have been rewarding for anyone who has invested for the long term. However, there is a very high investment risk as well. Equity markets are unpredictable and a stock that seems lucrative today can be an underperformer the following day. In such a scenario ETFs make much more sense as these are a basket of securities and not a single stock investment. Exchange traded funds are the only type of mutual fund schemes whose units are available for their selling at their current live market price throughout trading hours. These funds generate returns by tracking the performance of their underlying index with minimum tracking error. An ETF is a basket of securities whose portfolio comprises stocks that are listed on the index that it is tracking in the same proportion without any changes.
Key characteristics of Exchange Traded Funds
ETFs follow a passive investment style
Investors sometimes are skeptical about investing in mutual funds because of the constant fiddling of the portfolio by fund managers. Investors do not want their investment portfolio to be affected by human biases or be driven by human emotion. Such investors can actually consider ETFs because here the fund manager does not make decisions of buying and selling. ETFs are designed in such a way that they mimic the performance of the underlying securities of the index they are tracking and try to generate similar returns.
ETFs have a low expense ratio
When it comes to actively managed mutual funds, the fund manager is responsible for ensuring that the scheme is able to outperform its benchmark and generate returns from time to time. They also decide which stocks to hold on to, which ones to buy/sell. Since they are actively involved in managing a portfolio, active funds have a high expense ratio. However, when it comes to ETFs, they replicate the performance of the underlying securities with minimum tracking error. Here, the fund manager does not generate returns but is only responsible for ensuring that the ETF portfolio matches the composition of the underlying benchmark/index. This is why passively managed schemes like ETFs have a relatively low expense ratio that makes them a cost-effective investment.
ETFs are diversified
Investing in exchange traded funds is much safer than investing in direct equities because here investors get diversification. One single unit of an exchange traded fund is a combination of multiple high valued stocks. If one had to make direct stock market investment and buy such individual shares, they might have to shell out thousands of rupees. ETFs, give investors an edge over direct stock investments. Also, the stocks that comprise the ETF’s underlying benchmark may include stocks belonging to various market capitalizations spread across industries and sectors, thus offering true diversification to investors.