An Exchange Traded Fund (ETF) is a collection of securities that tracks a core index. They can invest in a variety of sectors and use different strategies similar to index mutual funds. ETF’s securities are listed on exchanges and trade like ordinary stocks all day.
Earlier the only way to invest in the domestic index was through a mutual fund, but the first ETF was introduced in 2001. Since their introduction, ETFs have witnessed exponential growth all over the world and have captured a significant slice of investment assets. They have evolved in terms of their product features, asset classes and investment objectives over time.
ETF asset classes have expanded considerably from equities to fixed income and commodities. They fall under passively managed funds as they follow a fixed strategy and follow a particular index, unlike actively managed funds. Passive funds can be ETFs and mutual funds. ETFs mix the flexibility of stocks and the benefits of mutual funds.
Let us have a look on some of the benefits of investing in ETFs mentioned below-
- Tax efficiency
ETFs are referred to as tax-friendly instrument, especially when compared to mutual funds. Mutual funds are more actively traded and incur more capital gains tax than ETFs due to structural differences. Mutual fund holders pass the tax to investors through the entire investment period while capital gains on ETF are incurred only upon the sale of assets by the investor. This implies that an investor can efficiently pick when to enforce ETF taxes on themselves.
Another benefit of ETF comes from low turnover. ETFs have low turnover implying little buy and sell options for a year. This results in lower taxes as low relative selling of holdings means fewer capital gains for the ETF holder. However, investors that are searching for ETFs that pay the best dividend must be cautious about the tax created from dividends. ETF holders can be subject to tax on the dividend of the fund even if the divisions are obtained in cash or are put back in the additional shares of the fund.
- Lower expense ratio
The expense ratio of ETF represents the cost incurred to operate and manage the fund. It represents the fee and operational expenses of the fund. Since ETFs follow an index, they have low expenses.
All managed funds incur operating expenses which include costs other than administrative expenses, marketing expenses, custody costs etc. irrespective of the composition. ETFs do not charge exit load fees and other types of management fees that are charged by mutual funds. An accrual of commission fees can be avoided while an investor is adding different stocks to the portfolio as there is only 1 transaction per trade.
ETFs are instead exposed to brokerage charges that are variable as per the brokerage firm and are lower in cost than mutual funds as they are traded on an exchange. All expenses related to client-service are to be borne by brokerage houses that hold ETFs in customer accounts implying lower costs.
- Portfolio diversification and risk management
ETFs allow investors to invest in a broader market. They can provide investors with a secure experience to a specific preferred market segment given the variety of sector, industry, style and country categories.
If an investor is not sure about buying a particular stock but has an interest in the overall sector, investing in shares attached to an index or bag of stocks comes up with diversified exposure and decreases stock-specific risk.
Each ETF share is in itself a mini portfolio representing a bag of partial stock shares. They are traded on virtually every major asset class, currency and commodity globally. An investor can buy/sell stock market instability or invest in the highest yielding currencies persistently through ETFs.
Investors who do not have a positive view on a market segment or particular may want to set up a short position to capitalise on that view. ETFs may be sold short as opposed to long stock holdings as a hedge against a decline in the market or specific sector.
- Easy to trade
ETFs are easy to trade and have a simple structure. They lower the obstacles that investors can have in understanding their investment. They can be traded all day at Exchange just like any other ordinary stock by buying or selling the shares of ETF through a broker. Share prices fluctuate all day based on varying the intra-day value of the assets within the fund. The pricing of ETF shares is persistent during regular hours of Exchange, and ETF investors know within flashes about the amount they paid or received to buy or sell their ETF shares.
ETF being a collection of securities eliminates the concentrated risk that generally arises in stock trading due to risk-diversification. The trading flexibility of an ETF helps investors to make their investment choices timely and place orders in different styles.
ETFs are frequently appreciated for their liquidity. Investment managers that see consistent inflows and outflows may use ETFs due to their liquidity and ability to appear for the market. ETFs make the buying process relatively simple without compromising on liquidity. ETFs trade frequently all through market hours just like stocks.
Hence, investors can use them to quickly enter and exit, making them a useful tool to raise cash when needed immediately. Most of ETFs are liquid, especially those that invest in actively traded securities.
Transparency means access to information about a company’s stocks or fund manager and the stocks in which the fund invests. Usually, an investor is not aware of the holdings of funds as mutual funds and investment funds publish about their holdings with a lag of time. ETF funds publish their holdings on a daily basis and thus helping investors to take prompt decisions on investment.
Hence, investors who make ETFs as a part of their investment can reap many benefits by diversifying investments, hedging the risk and gaining exposure to a particular sector.