What is an exchange-traded fund and how does it work?

Investors seeking exposure to an index may consider investing in optional ETFs. Exchange traded funds are one of the many types of mutual funds available today and are gaining popularity among different types of investors. While you may be familiar with equity funds, debt funds, or combo funds, ETFs are another category of mutual funds that work slightly differently. ETFs are mutual funds that mimic popular market indices like Nifty 100, BSE 100, Sensex, etc. These are passively managed funds that simply hold the stocks in the index that they are designed to mimic in exactly the same proportions as the index. Since fund managers do not make active calls on stock selection by holding the same stocks as those included in the index, these funds are passively managed.

Exchange-traded funds are great for new investors who want to test the water and aren’t comfortable with the increased risk associated with regular mutual funds.

Investing in an ETF has several advantages. First, because they are passively managed, they trade fewer funds than actively managed, forcing the fund manager to constantly look for stocks that can help them outperform the fund’s benchmark. This translates into higher portfolio turnover which translates into a higher tax burden. Funds pay taxes such as STT (Securities Transaction Tax) and Capital Gains Tax when buying or selling securities within their portfolio. This means that ETFs are more tax efficient and have lower fund management costs.

Second, ETFs also tend to have a lower expense ratio than actively managed mutual funds, which must employ highly skilled fund managers to generate active returns.

Third, ETFs provide investors with more convenience and liquidity because they are publicly traded and traded like stocks. Unlike actively managed mutual funds, where the NAV is calculated only once a day after the market close, investors can trade ETFs at real-time prices at any time during market hours.

ETFs offer better diversification because they contain all the stocks listed in the index that are rebalanced periodically. However, the lower risk that results from greater diversification in exchange-traded funds comes at the expense of potentially lower returns than other mutual funds. Actively managed mutual funds are more likely to achieve better long-term returns than passively managed funds because the fund manager uses their experience and actively accepts calls to buy better performing stocks and sell less efficient stocks. However, an ETF that mimics an index will contain all kinds of stocks, including the worst performing ones.

ETF investors should consider funds with a lower tracking error as a key performance indicator. Tracking error indicates the deviation of a fund’s performance from its benchmark. Since these funds mimic their respective indices, the tracking error should be close to zero. However, zero tracking error is not possible, as securities must be bought or sold to match the index when the index rebalances and therefore must bear certain transaction costs. However, the indexes do not have such restrictions. Investors who value a lower expense ratio and higher liquidity can include ETFs in their financial planning.

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