Exchange Traded Funds Vs Mutual Funds
Things to keep in mind before Investing in ETFs
Exchange traded Funds (ETFs) is a tradable investment fund or a basket of securities which tracks an index, a commodity, bonds, or a basket of assets like an index fund. These can be bought or sold via a brokerage firm and offer every conceivable asset class from traditional investments to alternative assets like real estate and venture capital. The units of an ETF are listed in stock exchanges and the Net Asset Value (NAV) varies as per market movements. In simple words, ETFs can be bought/sold in a similar manner, we buy shares without any restriction through the exchange.
ETFs are usually a bank created instrument which includes the plan of which securities are to be included. There are many types of ETFs, some of which are mentioned below:
Types of ETFs
- Market ETFs: These types of ETFs usually trace the main market index like the S&P 500 or NASDAQ. However, some market ETFs track low-volume indices as well, keeping in mind the objective of a market ETF is to imitate an underlying index and not surpass it.
- Foreign Market ETFs: Foreign currency ETFs facilitates investor to obtain an exposure on the foreign currencies. These are simple investment vehicles which trails foreign currency in an identical manner in which market ETF tracks its basic Index.
- Bonds ETFs: Bond ETFs are tricky when it comes to construction for the reason that they follow low-liquidity investment products. Bonds are not active on secondary markets because they're typically held till maturity. However, ETFs are actively traded products on exchange which gives the investors the advantage of the Bond while retaining the benefits of the ETFs.
- Sector and Industry ETFs: These ETFs generally track a specific sector or industry and facilitate gaining the exposure on certain market sector without buying the securities in many individual industries.
- Commodity ETFs: These are like the industry ETFs where certain area of market is aimed. On purchasing the commodity ETFs, the investor does not purchase the specific commodity but the derivative contracts of the underlying security.
- Style ETFs: These ETFs track a definite investment approach and tend to look at market capitalisation for instance large-cap value or small-cap growth.
- Derivative ETFs: There are some ETFs which doesn’t consist of equities at all and comprise of derivate contracts such as forwards, futures and options.
In comparison to regular shares, ETFs comes up with various advantages and disadvantages:
- ETFs provide a lower investment average costs as it would be difficult for an investor to buy all the stocks in the portfolio. These generally have lower expenses as they trace the index.
- Holding an ETF portfolio gives an investor an exposure to various stocks across various industries and hence offer risk management through diversification.
- ETFs offer an efficient and safe way of investing as it helps in capitalising the asset without buying it.
- Dividends from ETF schemes are tax excused for investors and ETFs, being index tracking commodities, can be used to generate profits owing to price differences between ETFs and other index products like forwards etc.
- The ETFs which are actively managed carry out a higher fee.
- Sector industry ETFs generally track a specific sector or industry and facilitate gaining the exposure on certain market sector without buying the securities in many individual industries, hence limiting the diversification.
- ETFs tend to replicate the indices and hence gives no excess returns. Actively managed mutual funds on the other hand generates alpha and outshines the ETFs.
Investing in ETFs: Financial Advisors usually recommend the ETFs to investors who have long-term objectives and intend to invest in equity without accepting much risk. The investor can buy/sell the ETFs on the exchange without impending on the fund house and such trades entice a brokerage. Just like the mutual Funds, ETFs also have a net asset value and they trade in real time. Although ETFs are gaining popularity, they encounter liquidity concerns as asset management companies do no deal directly with small investors. In such a case, there are chances that the quote offered may be less than the market price.
ETF Strategies: There are certain strategies investors use when trading in ETFs. Some of them are mentioned below:
- Dollar Cost Averaging: Dollar cost averaging is a technique of buying a fixed dollar amount of an asset on a frequent time interval irrespective of the fluctuating cost of the asset. Young Investors with little savings each month can consider investing in ETFs rather than low interest saving account.
- Asset Allocation: Asset allocation refers to the apportioning a part of asset to a different category for the purpose of diversification. ETFs offer lower threshold making it easy to implement a basic allocation strategy.
- Swing Trading: These trades are pursued to take benefit from the substantial changes in stocks or other instruments like currencies or commodities and may take few days or weeks to work out. An investor can prefer to trade an ETF that is based on a sector where he has an expertise or understanding.
Investors usually compare the ETFs with mutual funds which is not accurate as every asset class serves unique needs for customers.
Exchange Traded Funds Vs Mutual Funds
- Mutual Funds: Mutual Funds are professionally managed funds where the resources are collected and are traded from the multiple investors. These are handled by asset management companies (AMC) and usually disclose their results quarterly. Mutual funds don’t require a trading account and doesn’t have any brokerage as the funds are directly purchased. The average expense ratio is high and high tax on capital gains are levied due to the frequent trading. In mutual funds, Buying and selling is done from a fund house.
- Exchange Traded Funds: Exchange traded funds are the investment vehicles which traces the index and is listed on stock exchange. In comparison to mutual funds, these disclose their holdings every day. These funds require an opening of a trading account and brokerage needs to be paid. Since it is a passive investing, comparatively low tax is levied. In ETFs buying and selling is done between two investors in the secondary market.
Apart from the differences mentioned above, Both ETFs and Mutual funds represent professionally managed basket of individual stocks or bonds that we can invest in diversified portfolio using a single fund.
Things to keep in mind before Investing in ETFs: ETFs are no wonder a hot potato these days, but it is important for any investor to consider the following points before rushing into anything.
- While investing in ETFs, it is important to understand the index of the underlying ETF and the response of the index to different market conditions.
- An appropriate and sufficient due diligence is required for the proper implementation of ETFs in a portfolio, no doubt, ETFs offer huge benefits, but their value is contingent on how well they match in the portfolio. From market to index funds, from sector to regions, it should match the requirements of the portfolio.
- Investment strategy should be clear when investing in ETFs and Expense ratio and Tracking errors should be contemplated while picking the investments.
- Since ETFs can be traded only on stock exchanges, liquidity should be an important factor while making ETF investments. These may have high trading volumes but may not pose high liquidity.
- These funds offer various Pro’s and Con’s depending upon the investment horizon. So, it is important to consider if you want to invest in long-term or short-term securities.
- It is also important to consider the ETF’s holdings even if you are choosing sector investing. Scrutinize the stocks and if there are any securities which can hamper the performance, it is ideal to remove it.
- ETFs usually are a cost-effective investment in most cases, but you still have to consider the related costs of an ETF against comparable investments like indices. These may carry extra management fee and commissions and it is important to be aware of all such costs.
- While some ETFs offer tax advantages, there are some which are not so tax friendly. Also, tax implications vary from region to region.
- With a help of Inverse ETFs, you can take a short position without worrying about the market restrictions.
- It is always recommended that if you want to play the market, hedge the risk it has to offer. ETFs are subject to market risk such as currency fluctuations, so it is important to know your risk tolerance.
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