From fixed deposits to post savings to a mutual fund, Indian investors have come a long way in their quest for high returns. There are very few Indian investors who try their hand at direct equity investment as most of them are averse to taking high-risk investment. The mutual fund has hit the right cord with Indian investors because it perfectly channels all their needs - it is not as risky as the direct stock market investment and, most importantly, it gives handsome returns. The kind of returns FD and post can never match. But as we evolve, there are more and better investment mediums which keep coming. Exchange Traded Fund (ETF) is one such investment medium which has started gaining popularity. What is ETF? Is it as good and as safe as the mutual fund? Questions like these and much more have started to inundate investors mind. Let's explore all the facets of ETF and try to find out whether you should invest in it.
What Is ETF?
An exchange-traded fund (ETF) is a bundle of securities that you can buy or sell on a stock exchange through a brokerage firm. ETF is in almost all asset classes, from traditional investments like gold to new assets like equity, commodities or currencies. Such is the fluidity of ETFs that these days there is a buzz about an ETF on bitcoin. An ETF is a marketable security which is traded on an index like a stock a commodity, bonds, or a basket of assets like an index fund. One quality sets it apart from mutual funds is that an ETF trades just like a company stock on stock exchanges. The experience price ETFs keeps changes all through the day as per the shares (in equity ETF) are bought and sold. The biggest advantage of ETFs is that it has much higher daily liquidity and considerably lower fees than mutual funds which makes it an attractive alternative for retail investors.
Types Of ETFs
As we are comparing all the aspects of ETFs with that of mutual funds, the reasonable question to ask would be - like Mutual funds are there different types of ETFs? In mutual funds, we have equity funds, debt funds and balanced funds. As we mentioned above that ETF is like a basket of securities i.e. bonds, shares, bitcoins, etc. From this, it becomes absolutely clear that ETF is a flexible and a dynamic investment platform which means there must be more than just one type of ETFs. Let's find out the different types of ETFs. As ETF is still a medium which is relatively less popular, most of the ETFs mentioned below are not available in India but these are ETFs which are being traded in the US as well as in some foreign exchanges.
Market ETFs: Designed to track a particular index like the S&P 500 or NASDAQ
Bond ETFs: This ETF is formulated to give exposure to practically every type of bonds available i.e. the U.S. Treasury, corporate bonds, municipal bonds, international bonds, high-yield and many more.
Actively managed ETFs: This ETF takes an aggressive approach and tries to beat an index it is following. This is unlike most ETFs, which are meant to track the index.
Sector and industry ETFs: Like thematic mutual funds which focus on a certain sector and industry, this ETFs is designed to give exposure to a certain industry e.g. pharmaceuticals or information technology.
Commodity ETFs: Just as the name implies this ETF is created to track the price of a commodity, such as gold, crude oil, copper, etc.
Style ETFs: A style ETF tries to follow an investment style or focuses on the market capitalisation i.e. large-cap value or small-cap growth.
Inverse ETFs: This ETF is different than the conventional ETFs. Here the intention of the ETF is to gain from a drop in the value of the underlying asset or index or whatever security there may be in the ETF basket. This is comparable to taking a short position in the future's market.
Expense Ratio Of ETF Is lesser Than Mutual Fund
For both mutual funds and exchange-traded funds (ETFs) investors are charged an expense ratio. This charge is to cover the operating expenses of the funds. The expense ratio is a critical part. The expense ratio includes many operational costs i.e. administrative cost, distribution cost, compliance cost, management cost, marketing cost, shareholder services, record-keeping fees, etc. The sum total of all these costs accounts for a certain percentage of a fund’s average net assets. The expense ratio, which is calculated annually and published in the fund’s fact sheet and shareholder reports, has a straight impact on the fund’s returns to its shareholders. Hence, also on the value of your investment. In simple terms, the higher expense ratio of fund simply means you will take a hit on your returns. A heavy expense ratio can eat into your returns considerably. Normally, investors are not vigilant about this element but that's a big mistake.
The expense ratio of ETF is much lesser than that of mutual funds. As its operational cost is less it has the potential to give a higher profit margin.
Then Why Your Financial Advisor Doesn't Recommend ETF?
Now you must be thinking if ETFs are so good why your financial advisor doesn't recommend it to you? That's a good question. The answer lies in how much your financial advisory gets by recommending a certain fund. Financial advisers get compensated for their expertise either by the commission or by a yearly percentage of your entire portfolio. The cost normally ranges between 0.5-2%. It's the same way as you pay a yearly percentage of your fund to the fund manager. In order to skip the annual charges, if you exit the fund before finishing one year you have to pay a hefty exit load that ranges between, 1-3%, to the Asset Management Company (AMC). Therefore when you try to skip the annual charges, financial advisor receives his/her share through exit load. And if your advisor gets paid by the load then there is no surprise if he/she doesn't recommend ETFs for the commission they get from the load is far greater than ETFs. Even the money the AMCs make from mutual funds is way bigger than the revenue of ETFs. This is one of the reasons AMCs spend so much money on creating awareness about mutual funds and are, to some extent, apathetic towards ETF.