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What is an Exchange Traded Fund & how it’s different from Mutual Funds?

Ashish M. Shaji

| Updated: Sep 18, 2021 | Category: SEBI

What is an Exchange Traded Fund & how is it different from Mutual Funds?

Exchange Traded Fund is similar to a stock and can be referred to as basket of securities that trade on the stock market. Exchange traded funds or ETF pool financial resources of different people and purchase various tradable monetary assets through it such as shares, debt securities etc. Majority of the ETFs are registered with the capital markets regulator- SEBI. It is an enchanting option for investors with limited expertise in the stock market.

How does Exchange Traded Fund (ETF) work?

ETFs share characteristic features of shares as well as mutual funds. They are traded in the stock market like shares produced through creation blocks. ETF funds are listed on all major stock exchanges and can be purchased and sold according to the need during the equity trading time.

Changes in the share price of ETF depend upon the costs of the underlying assets in the pool of resources. In case the price of an asset or two rises, the share price of ETF rises proportionately and vice-versa.

The dividend value obtained by the share-holders of the ETFs is based on the performance and asset management of the concerned ETF company. It can be managed actively or passively.

Those that are managed actively, portfolio manager operates them after assessing the stock market conditions carefully and undertaking calculated risk by making investment in the companies with high potential.

On the other hand, those that are managed passively follow the trends of specific market indices, only investing in companies listed on the rising charts.

What are the types of ETFs?

Some of the types of ETFs in India are as follows:

What are the types of ETFs?
  • Equity ETF-

It represents companies investing in shares and other forms of equity of different organizations.

  • Gold ETF-

It is a commodity exchange traded fund involving physical gold assets. By purchasing the shares of the company, you can become the owner of the gold on paper, without the burden of asset protection.

  • Debt ETF-

Those enterprises that trade in fixed return securities like debentures and government bonds are known as Debt ETFs.

  • Currency ETF-

This type of ETFs benefit due to the changes in the exchange rates. Currency of different countries are bought based on the calculated predictions regarding the future performance of the currency. These ETFs follow the stock exchange trends and also the political and economic scenario of the respective countries.

Benefits and Shortcomings of Exchange Traded Fund

Whenever we discuss something, we need to weigh its benefits and shortcomings in order to deduce its true potential. Here in this segment, we have discussed the benefits and shortcomings of ETFs. Let’s start with Benefits first:

Benefits-

  • Diversified pool of securities

When you purchase shares of a company, it keeps you limited to the performance of the company of which you bought shares. It can be a risky proposition. However, when you invest in ETFs, it allows you to keep your finances spread over equities of different countries, thereby reducing the risk substantially. In case an asset doesn’t perform well among the resources in ETF, it can be covered by the growth of other assets.

  • Beneficial than mutual funds

Another benefit of investing in ETF than investing in mutual funds is reduced expenses as there are numerous charges in the mutual funds. It can increase the total cost incurred, causing the total expense ratio to go up. ETFs have considerably lower expense ratio.

  • Tax friendly

ETFs are tax-friendly in nature. The relative amount of fee levied on ETFs is lower than the one levied on mutual funds.

Shortcomings-

  • Brokerage fees and Demat account

ETFs are traded like shares hence there are various expenses which have to be incurred to buy them. Fund managers do that.

One can opt to transact on his own on the share market, thereby eliminating the role of fund managers. However, a demat account needs to be opened and operating such account could be a difficult task for a novice.

  • Volatility of stock market

Companies on the stock exchange are subject to price fluctuations according to market trends. Therefore earning a profit or incurring a loss can be subject to stock market.

  • Diversification

ETFs[1] have moderate diversity. They are managed passively. ETF organizations ignore the potential of small scale companies.

ETFs vs Mutual Funds

Here we compare the two- ETFs and Mutual Funds.

EXCHANGE TRADED FUNDS  MUTUAL FUNDS
These are traded during the course of a trading day.  These are traded during the course of a trading day.
  They have lower operating costs.    They have varying operating expenses.
  No minimum investment specified.      Most of them have a minimum investment specified.
  They offer tax benefits to investors  They have more tax liabilities as compared to ETFs.
  It can be purchased and sold any time on the stock exchange.    It can be purchased directly from the funds at NAV price, which is fixed.
  They have higher liquidity.    They have lower liquidity as compared to ETFs.
  ETFs don’t have a time limit on selling an asset.    Some mutual funds levy penalty on selling share early.

Conclusion

Having an understanding of the investment choices available is critical and also working on investment strategy is one of the hallmarks of a good investor. Before you search out for an ETF to invest in, ensure that you have a policy in place and be informed on how ETFs function. Make sure you follow a smart investment strategy and invest within your boundaries.

Read our article:Difference between Stocks and Mutual Funds

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Ashish M. Shaji

Ashish M. Shaji has done his graduation in law (BA. LLB) from CCS University. He has keen interests in doing extensive research and writing on legal subjects especially on criminal and corporate law. He is a creative thinker and has a great interest in exploring legal subjects.

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