The first thing that stock market enthusiasts try is to replicate the stock market index. However, it’s a tad bit complex to do so. That’s where ETFs come into play.
Not everyone is an active investor. Not everyone has the intellect or time (or both) to research industries, analyze companies, select the best stocks and invest in them. This makes passive investing a vital tool for a certain class of investors. And one means of doing that is through Exchange-Traded Funds (ETFs).
ETFs make it possible to invest in an index fund on the stock market. Due to this, it is considered a disruption in the mutual fund industry.
So, want to learn about this innovation? Here you go.
What is an Exchange-Traded Fund?
An Exchange Traded Fund (ETF) is a passive investment tool that pools the resources, employs them in different asset classes, and tracks a particular index or commodity price (instead of beating them). You may consider them as mutual funds that invest in equity, debt, commodities, etc. But here's the catch... They can be traded in the stock market, just like shares.
In simple words, they are a hybrid of mutual funds and shares. So, ETF makes it possible for you to invest in a mutual fund without worrying about the liquidity of your investments. It also solves the problem of high fees levied by AMCs in various ways. For example, you have to pay an Expense Ratio, exit load, entry load, and other charges while investing in a mutual fund. But that is not the case with ETF.
Now that you have a sound understanding of ETFs, let’s look at the different types of ETFs.
Different types of ETFs
As mentioned above, ETFs are not limited to one asset class. That is why there are different types of ETFs for various assets:
They are the most common type of ETFs which invest in equity. After all, equity is the best and the most popular segment to earn high returns.
Generally, equity funds track equity indices like Nifty and Sensex. That is why they invest in the best companies. But they may deviate from the index as well. And purchase stocks that are not in the index. It helps the investor to diversify his portfolio without investing a high amount.
What's more, they are not limited to the cash segment of the stock market. ETFs can invest in futures and options as well. It gives an opportunity of earning high returns. (But you should remember that the higher the returns, the higher is the risk involved).
Besides investing in equity, some ETFs invest in debt securities. As you know, appropriate asset allocation is the key to making an ideal portfolio.
You may be aware of the returns offered by banks on term deposits. Public Sector Banks offer as low as 5% interest! It may discourage you from investing your hard-earned money in banks, to lose it to inflation.
That is why fixed-income funds are a better alternative to invest in debt instruments. By investing in them, you could at least cope up with inflation, if not beat it.
Generally, the experts believe that commodities are inversely related to the stock market. It helps in hedging the risk of the overall portfolio. What if the entire stock market falls, just like it happened in 2008 or 2020? That is why commodities should be a part of your portfolio.
But you might not be aware of the process of investing in commodities. That is where commodity funds come to the rescue. These ETFs track the prices of commodities or the commodities producers like IGL, BPCL, etc. It helps to diversify your portfolio hassle-free.
But they are not much preferred by the investors. It is so because the movement in the prices may not reflect in the underlying ETF.
Currency markets have the edge over the stock markets in some aspects. They are open 24*7, have lower costs and help hedge the foreign exchange risk. What’s more, it diversifies your portfolio to the next level.
But not everyone can actively engage in forex markets, right? That is why the investors prefer the currency funds.
Currency funds invest in foreign stocks, international mutual funds, and other instruments. It helps in earning extra returns due to the depreciation of the rupee. For example, consider the average returns in the US are 10%. And the rupee depreciates by 5% annually. So, you can earn 15% returns (not exactly though) on the same investment. Isn’t that delightful?
Equity instruments help your investments to grow significantly due to the power of compounding. But what is the point of investing if you have to sell them to maintain a sufficient bank balance?
In this case, Real Estate ETFs bring an end to your problems. As the name suggests, they invest in real estate. Although they don't have much growth potential, they ensure sufficient bank balance. It is so because they have to distribute more than 90% of their income to the shareholders as dividends.
Hence, they act as a source of passive regular income. So, based on your investment objective, you may consider making the real estate funds a part of your investment portfolio.
As the name suggests, you expect these funds to be special among the peers. Well, you are right. They are indeed special. They are categorized as Inverse Funds and Leveraged Funds.
What if we tell you that you can profit even when the stock markets fall? That is what inverse funds do. They invest in derivatives such that they earn profit from a decline in the value of stocks. It is similar to shorting the stock. Hence, it can be your call when the bears beat the bulls.
If you find the inverse fund special, you will consider a leveraged fund to be no less. They use every way to multiply the profits earned. In simple words, they use leverage techniques like options trading, short selling, and margin trading to get magnificent profits. They are suitable for you if you want high returns without investing much. But remember that the risk of losses increases proportionately as well.
People believe that mutual funds are a one-stop solution for investing if you don't have the expertise of the stock market. ETFs are an emerging investment tool that is a step ahead of mutual funds. But it doesn’t mean that they are 100% perfect. They have drawbacks of their own, like brokerage charges & the fees involved, the price volatility, etc.
But as it seems, the benefits overshadow these disadvantages. That is the reason why you can consider ETFs as the future of mutual funds.
In the end, remember that ETFs can offer many attractive features. But their long-term value depends on how well they fit into any individual portfolio. So, it’s always advisable to decide on your investment objectives, see if it fits your risk appetite, and only then proceed with your investments.