Are Exchange Traded Funds (ETF) Suitable For Your Investment Portfolio?

What are ETFs?

Exchange Traded Funds (ETFs) are like mutual funds as these are also bundles of investments in different assets clubbed together. This being the only similarity, they are different from mutual funds in significant ways.

ETFs are mainly trackers of a particular index (typically from a single sector or theme) and are traded like stocks. An investor can buy and sell these during market hours and just like equity place advanced orders on purchases like limit and stops.

Mutual funds, on the other hand, have a net asset value of the fund calculated at the end of market hours and typically purchased after the NAV is computed.

Mutual funds are usually preferred as these funds are actively managed by expert asset managers and outperform benchmarks.

Varieties in ETFs

When it was first introduced in the USA, ETFs were simply products that tracked the equity indices but later went on include other asset classes like bonds, real estate, commodities and currencies.

Now, ETFs have become very specific in their focus, giving you the option to choose a certain sector or theme that appeals to you. Whether you are optimistic of gold (commodity), dollar (currency) or a business sector, you can make your pick with ETFs.

Fees:

Generally, ETFs have a lower expense ratio when compared to mutual funds. These are offered by brokerages as these are bought and sold just like equity, which means that every time you buy or sell, you will have to pay a commission. This means that despite the low fee if traded often, these charges will take a toll on your savings.

Risks:

Mutual funds, as well as ETFs, are considered less risky when compared to individual company stock as these funds allow diversification to dodge a fall that would affect equity. However, the risk factor would depend on the type of ETF you choose to invest in.

For example, if you opt out your money on an ETF linked to Nifty 50, it would be less volatile considering the diversity of the strong performers, however, gold or crude ETF will fluctuate.

It is important to understand and track the risks associated with the underlying assets. If you a passive investor who cannot keep tracking investments, you can bet on ETFs based on benchmark indices, however, the returns from these will be limited the market returns. They will fetch you good returns considering long term perspective and low trading fees.

Liquidity:

In India, there is an issue of liquidity among ETFs. Though listed on the stock exchange, if not traded frequently it will be an issue because if there isn't enough trading interest, you won't be able to get out of it fast enough, depending on your size of the position. There will be a wider gap between the bid and ask price.

In case of actively managed funds (like mutual funds), you can sell the units back to the fund house and have no impact cost. It is wise to check the spread and market movements of the of the ETF over the past week or month to judge the movement.

Exposure and size of the ETF:

Restrict your exposure to ETFs as the product is still young in the Indian market and as mentioned before there will be a problem of liquidity. There could be scope for it to grow further but at present, there is still room for improvement.

For example, the government issued Bharat 22 ETF is based on 22 public and private sector units that the government wishes to divest from. It does not follow the basic fundamental concept of ETF, that is to track an existing index or asset. A new index based on these stocks is being tracked. Also, this index is not as flexible as even the Nifty 50 or Sensex, that is revised. Furthermore, the best time to sell will be decided by the government.

It is therefore important to choose the ETF you invest in wisely by considering factors like the diversification of the underlying fund and the liquidity.