What is ETF? Advantages of Exchange Traded Funds

13 Nov 2021|

2 min read |

by ICICI Securities Team

Introduction:

The first successful ETF was launched in America in 1993 to track the Standard & Poor’s 500 Index (S&P 500) and is one of the highest traded ETFs to date. In India, the first ETF was launched in 2001 to track the Nifty 50 Index. ETFs are a cost-effective, passive alternative to mutual funds that empower an investor with exposure to the market and diversify their portfolio. Unlike a mutual fund actively managed by a fund manager, the predefined objective of an ETF is not to outperform the market but to replicate the performance of the underlying index. In short, ETFs are a safe option to track the performance of the market through an index and invest accordingly.

Additional read: Types of ETF

Advantages of ETFs:

Cost-effectiveness: Since ETFs only track an index without surpassing it, administrative costs to manage it are much lower than those incurred by mutual funds .
Passive Management: Since the objective of ETFs is to mimic the market, the fund manager needs to make periodic changes only to correspond to a market index. That is a crucial distinction from mutual funds, where the fund manager continuously trades the securities in the basket to outdo the market.
Low managerial risk: Since ETFs are passively managed and are tied to a particular index, it involves lower risks of organisational errors. Here, the investor need not rely on the judgement of the fund manager, like in a mutual fund, to constantly make the best trading decisions. Instead, the investor is reliant only on the self-stabilising market.
Diversification:When compared to mutual funds, ETFs is an inexpensive vehicle to diversify a portfolio along with exposure to the market.
Liquidity: ETFs can be traded on the market exchange, like any other stock , but a key difference is that they can be traded intraday, unlike mutual funds that trade at the end of the day. That can be helpful if the market is volatile.
Tax-effectiveness: Being passively managed and structured to mimic the market, capital gains and income from ETFs may not be high enough to move up the tax threshold of the investor.
No minimum investment: ETFs can be purchased in small amounts to gauge the performance of a market index.
Sector exposure: ETFs can harness the performance of any specific sector, allowing an investor to initially experience a portion of an industry where they want greater openness in the future.

Best examples of ETFs in India:

iShares MSCI India Small-Cap ETF providing diversified exposure to small public companies in India
Wisdom Tree India Earnings Fund (EPI) focusing on large Indian companies eligible for purchase by foreign investors
First Trust India NIFTY 50 Equal Weight ETF tracking the performance of the most liquid securities listed on the National Stock Exchange of India

Additional read: Difference between large-cap mid-cap and multi-cap companies

Conclusion

ETFs could be the best alternative to mutual funds if the investor is looking for a relatively risk-free investment. At low cost, ETFs allow for diversification of portfolios and exposure to the market. They are friendly vehicles to gauge market performance without incurring heavy losses. However, lower risk also means lower capital gains and income. Further, since ETFs only track a market index without aiming to outdo it, it may disappear altogether if that market index goes obsolete.

Disclaimer

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