Exchange Traded Funds (ETFs) come to mind for those looking for an alternative to mutual funds. Wealthy and retail investors are turning to ETFs. Mutual fund companies are making ETFs available to attract investors.
With investments in ETFs, the risk is low, and returns are high. But there are some disadvantages too. So before discussing its advantages and disadvantages, let us know what an ETF is and how to choose the right ETF.
What is an ETF?
ETFs work a bit like stocks. It is a mix of certain securities that can be traded on demand in the stock market with features of mutual funds. Money is collected from investors, and the amount is used to buy shares and debt securities. Together they are considered one ETF unit. They are traded in the stock market. Stock market-like value increases.
ETFs work like stocks and mutual funds. Some ETF blocks act together like shares in the stock market. Moreover, ETF funds are listed on almost all stock exchanges. These are traded during trading hours. Besides that, an ETF’s unit value varies depending on the value of the shares and securities it contains. As the price per unit increases, the ETF value increases. Investors may also receive dividends based on the ETF Company’s revenue and profits.
How Does an ETF Work?
A fund provider will design a fund to track the fund’s overall performance, which includes the fund’s internal assets. They then sell shares of this ETF to investors. In the meantime, an investor owns a percentage of the ETF but does not own the assets the ETF holds.
Furthermore, Investors receive reinvestments or dividends from the stocks included in the ETF. The ETF’s number of shares can change daily because it can issue new shares and redeem existing shares. This helps keep the ETF’s market price high or low in line with the underlying securities.
Things to be Considered While Choosing Right ETF
There are two key factors to consider when choosing an ETF or Index Fund. One is the expense ratio. Nowadays there is a lot of competition among Index funds. Direct plans of index funds are available with an expense ratio of 10–15 basis points (0.1–0.15 per cent). So, there is no need to pay more than that.
The second is a tracking error. It tells how well an index fund has performed in terms of returns compared to the index it is investing in. It also reflects the efficiency of the index fund management team. Lastly, a scheme with a lower expense ratio and fewer tracking errors will be better.
Benefits of Investing in ETF
- ETFs provide some of the best diversification. Not only can you invest in multiple companies at once, but you can also invest in different industries or global markets.
- Through market timings, you can trade in an ETF just like any other stock, ensuring you can act quickly based on market news and local & global events.
- Advanced trading mechanisms such as buying on margin or creating limit or stop orders.
- ETFs allow very small investments, which means that even beginner investors or those with small savings can invest.
- An ETF provides transparency. Your ETF discloses its holdings at the end of each day, and you can reassure yourself that the intrinsic value of the assets is recognized for you.
Disadvantages of investing in an ETF
- It may be difficult to sell an ETF unless it is traded frequently.
- It may close if an ETF does not have enough assets to cover administrative costs. This may lead to you selling your shares earlier than you would like and at a loss.
- There is also the risk of a tax liability that you may not have anticipated at the time.
- However, the advantages of an ETF far outweigh the disadvantages associated with it.
An ETF has low risk and high Diversity. It is an ideal choice for diversified portfolios for individual investors. ETFs have low expense ratios and provide an opportunity to invest the dividend immediately. Another factor here is the tax depending on the ETF. They are advantageous when compared to things like mutual funds.
In addition, ETFs can be purchased on leverage and then sold short. Also, The Expense ratio of the ETF is low compared to other funds. Dividends can be reinvested immediately. ETFs have fewer taxes than mutual funds. There are also disadvantages. Investors are more likely to limit themselves to large stocks only. Long-term investors have a time horizon of ten to fifteen years. So, they don’t get an intraday benefit.