Exchange Traded Funds (ETFs): Meaning, Types & How to Invest

Exchange-Traded Funds (ETFs) have become a popular investment vehicle for both new and seasoned investors in India. Offering a blend of flexibility, relative low cost, and diversification, ETFs are steadily making their way into long term wealth building strategies.

If you’ve ever wondered what is ETF, how it differs from traditional mutual funds, or how to get started, this guide will walk you through everything you need to know.

ETF Meaning

Before diving deeper, let’s understand the ETF full form it stands for Exchange Traded Fund. An Exchange-Traded Fund (ETF) is a type of investment that you can buy and sell on a stock exchange, just like regular securities. It’s designed to track the performance of things like an index (such as the Nifty 50 or Sensex, etc.), a commodity, or a group of assets. The ETF meaning lies in its structure it holds a collection of securities, such as stocks, bonds, or commodities, and tracks a particular index.

When you invest in an ETF, you're essentially buying a small piece of a larger portfolio that follows a specific index. The goal is not to beat the market but to closely follow its performance.

What sets ETFs apart from mutual funds is that they trade in real time during market hours, and their prices change throughout the day. They’re also known for being cost effective and easier to buy and sell, which makes them a  option for investors looking for a simple, low fee way to invest.

What is an ETF?

An Exchange-Traded Fund (ETF) is a fund that pools money from investors and uses that pool to invest in a basket of assets. The fund is listed and traded on a stock exchange. Unlike mutual funds that are priced once at the end of the day, ETFs can be bought and sold throughout the trading session.

They provide exposure to a diversified portfolio at a relative lower cost, making them an excellent option for investors who prefer passive investing or want to track specific sectors or indices.

How do ETFs Work?

Exchange Traded Funds function by mimicking a benchmark index. Fund houses create ETF units that are traded on stock exchanges. Prices fluctuate in real time, depending on demand and supply similar to how stock prices behave.

The value of an ETF unit reflects its Net Asset Value (NAV). Investors benefit from price efficiency, liquidity, and transparency. For example, a Gold ETF mirrors the price movement of physical gold, making it a convenient tool for those seeking gold exposure without storage concerns.

What are the Costs of Investing in ETFs?

ETFs are known for their relative low expense ratios, especially when compared to traditional mutual funds. But they do come with a few costs that investors should be aware of. Since ETFs are traded on stock exchanges, just like regular shares, you’ll need to pay a brokerage fee every time you buy or sell.

On top of that, there’s the Securities Transaction Tax (STT) and other standard trading charges like the bid-ask spread, which is the small price difference between what buyers are willing to pay and what sellers are asking for.

How to Select ETFs?

Here are a few factors to consider before investing:

• Underlying Index: Choose an ETF that aligns with your investment goals
• Expense Ratio: Lower expense ratios mean more of your money stays invested.
• Tracking Error: Look at how closely the ETF tracks its benchmark index. A lower tracking error is preferred.
• Liquidity: Highly traded ETFs offer better exit opportunities.
• AUM (Assets Under Management): Higher AUM generally indicates stability and confidence in the fund.

Types of ETFs

There are many categories of ETFs catering to different investor needs:

1. Index ETFs

These funds aim to replicate the performance of a specific stock market index, like Nifty 50 by holding the same stocks in similar proportions.

2. Bond or Fixed Income ETFs

These provide investors with access to bonds such as government or corporate debt, helping diversify portfolios with steady income.

3. Sector ETFs

Focused on particular industries like technology, healthcare, or energy, these ETFs let you invest in a specific segment of the market.

4. Commodity ETFs

These track the prices of physical goods like gold, oil, or agricultural products, offering exposure to commodity markets without owning the assets directly.

Benefits of Investing in ETFs

The ETF benefits make them an attractive option:

• Relatively Low Expense Ratios: Because most ETFs are passively managed.
• Diversification: A single ETF can provide exposure to dozens or even hundreds of securities.
• Liquidity: Easy to buy and sell anytime during market hours.
• Transparency: Holdings are disclosed regularly.

What are the Risks of Investing in ETFs?

Just like any investment, ETFs are not without risk:

• Market Risk: ETFs are market linked instruments.
• Tracking Error: Some ETFs may not perfectly mirror the benchmark.
• Liquidity Risk: Less popular ETFs may have wider bid-ask spreads, impacting buying/selling efficiency.
• Sector Risk: Thematic or sectoral ETFs are subject to industry specific volatility.

Points to Note Before Investing in ETFs

• Make sure you have a Demat account and trading account.
• Be aware of the bid-ask spread and total transaction cost.
• Study the historical performance and underlying assets.
• Understand how the ETF fits into your overall asset allocation strategy.

How to Invest in ETF?

If you’re wondering how to invest in ETF in India, here’s a quick step by step guide:

1. Open a Demat and trading account with a registered broker.
2. Research ETFs based on your financial goal.
3. Place a buy order during market hours, just like you would for a stock.
4. Track the performance via your broker’s platform or financial apps.

Difference Between an ETF and an Index Fund

• Both ETFs and Index Funds aim to track market indices and follow a passive investment approach. However, they differ in how they're traded and accessed.
• ETFs trade on stock exchanges like regular security, with prices changing throughout the day. Index Funds, in contrast, are priced once daily based on their Net Asset Value (NAV).
• To invest in ETFs, you need a demat account, as they’re only available on exchanges. With Index Funds, you can invest directly through a mutual fund without needing a demat account, often with lower minimum amounts.

What Happens When the Components of an Index Change?

An index’s list of stocks can be updated from time to time. This usually happens if some companies no longer fit the rules set by the index provider, or if there are better options to include instead. These changes are typically announced well in advance.

When this occurs, the fund that follows the index will adjust its holdings by selling the stocks that are removed and buying the new ones added. This adjustment doesn’t affect the number of units an investor holds their investment continues to track the updated index.

The only possible difference is a slight change in how closely the fund matches the index’s performance, known as tracking error.

Conclusion

Exchange Traded Funds offer a modern way to invest that blends the stock trading and mutual fund investing. From beginners to seasoned investors, ETFs can serve a wide variety of goals whether it’s building a retirement corpus, diversifying risk, or just getting started with equity markets. As always, evaluate your goals and consult with a financial advisor to decide if ETFs fit your investment strategy.

FAQs

1. What do you mean by Exchange Traded Fund?

An Exchange Traded Fund is a fund that trades on the stock exchange and invests in a basket of assets like stocks, bonds, or commodities. It combines the flexibility of stocks with the diversification of mutual funds.

2. Is an ETF a good investment?

Yes, ETFs are considered a good investment for cost conscious investors seeking diversification, transparency, and long term growth. However, returns are subject to market risks.

3. Do ETFs pay dividends?

ETFs usually reinvest the dividends they receive back into the fund

4. Should you invest in ETFs?

ETFs are suitable for both beginners and experienced investors looking for low cost and diversified options. They’re especially beneficial for passive investors who want to mirror index performance.

5. Is ETF tax free?

No, ETFs are not tax free. For more details, please visit the Kotak Mutual Fund tax reckoner.

6. Can I sell ETFs anytime?

Yes, ETFs can be bought or sold at any time during trading hours, offering better liquidity than mutual funds.

7. When is the ETF NAV calculated?

The NAV of ETFs is updated periodically during the trading day, but the most relevant price is the market price, which reflects current demand and supply.

8. What is the difference between ETFs and actively managed mutual funds?

ETFs are mostly passively managed and aim to replicate a specific index, while actively managed mutual funds rely on fund managers to beat the market, often with higher fees.

9. What is the scheme characteristic of Exchange Traded Funds in India?

ETFs in India are structured to offer real time trading, index tracking exposure and low expense ratios, with options across equity, debt, commodities, and thematic strategies.

 

Disclaimers

Investors may consult their Financial Advisors and/or Tax advisors before making any investment decision.

These materials are not intended for distribution to or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation.  The distribution of this document in certain jurisdictions may be restricted or totally prohibited and accordingly, persons who come into possession of this document are required to inform themselves about, and to observe, any such restrictions.

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