Exchange Traded Funds (ETFs): Meaning, Types & Complete Overview

Exchange-traded funds (ETFs) are changing the game of wealth creation for investors. These are a low-cost, transparent method to invest across different asset classes offering the versatility of stock trading and the diversification of mutual funds. Whether you want long-term growth, stable income, or risk protection, knowing what is ETFs presents a streamlined solution best suited to your investment objectives. 

With their simplicity of trading, tax advantages, and wide market exposure, ETFs have become a popular choice among contemporary investors. Read on to find out how ETFs function, their advantages, and how you can invest with caution!

Understanding ETFs

Exchange-traded funds (ETFs) are mutual funds traded on stock markets like stocks. They collect funds from investors and use them to buy a range of assets that include stocks, bonds, commodities, or any combination of them. Therefore, you can buy and sell ETFs at market value during the day.

They also have lower fee ratios compared to mutual funds and offer diversification, liquidity, and tax benefits. ETFs are available in different forms, such as index-based, actively managed, and sector funds, to suit different investment approaches. Investors utilise ETFs for long-term appreciation, income generation, or protection against market risks.

Working of ETFs

Exchange-traded funds (ETFs) work by enabling investors to purchase shares in a diversified portfolio of securities without outright ownership of the underlying assets. The ETF provider forms a fund that mirrors the performance of an index, commodity, or asset class and then offers shares to investors. 

Even though shareholders are a part of the ETF, they do not directly own the underlying securities. They can, however, receive dividend payments if the ETF holds dividend-paying stocks.

Prices of ETFs fluctuate throughout the trading day. This is because they are listed on exchanges like stocks. As opposed to mutual funds, which have a single daily price, ETFs can be bought and sold at market prices. 

Although ETFs track the performance of their underlying assets, variables like management fees create minor discrepancies in returns. This architecture transforms ETFs into a versatile, affordable, and easy investment vehicle for a range of financial objectives.

Advantages of Investing in ETFs

Having a vivid idea of what is exchange traded fund will provide investors with many significant benefits, which is the reason they have become widely popular in diversified portfolios.​

• Diversification

ETFs allow investors to get exposure to a wide universe of securities across various markets, industries, asset classes, or countries. Such diversification minimises the effect of any one investment’s weak performance on the entire portfolio.​

• Cost Efficiency

As a result of their passive management, ETFs normally have lower expense ratios than actively managed funds. These cost savings enable investors to keep more of their gains in the long run.

• Liquidity and Flexibility

Traders buy and sell individual stocks and ETFs throughout the trading day at market prices. This intraday trading flexibility provides investors with more flexibility when it comes to managing their investments.

• Transparency

Most ETFs report their holdings daily, giving investors direct visibility into what they hold. This transparency helps investors make informed decisions and is in line with investor strategies.

• Tax Efficiency

ETFs tend to have less internal trading because of their design, reducing capital gains distributions within the fund. This can reduce investors’ tax burdens relative to traditional mutual funds.

Different Types of ETFs

Understanding what are ETFs in the stock market will help you understand their segmentation. The primary types of ETFs are:

• Equity ETFs

Investors can buy equity ETFs, which are invested in stocks and equity mutual funds, and trade them at market prices with transparency and lower costs. They are further divided into:

• Market-Based ETFs: Segmented based on market capitalisation (small-cap, mid-cap, large-cap).
• Sector-Based ETFs: Invest in particular industries, e.g., banking, pharma, or automobiles.
• Factor-Based ETFs: Follow indices based on factors such as volatility, momentum, and alpha.

• Debt ETFs

These ETFs invest in fixed-income instruments such as government bonds, debentures, and commercial papers. They offer stable returns with low default risk, making them a relatively safer investment.

• Commodity ETFs

Commodity ETFs invest in physical commodities such as gold, silver, and platinum. Gold ETFs are the most sought-after, providing an economical alternative to investment in physical gold.

• Liquid ETFs

Liquid ETFs invest in money market instruments and short-term government securities, reducing risks related to market volatility and generating stable returns.

• Index ETFs

Index ETFs follow leading stock market indices like Nifty, Sensex, and Nifty 100. Their returns reflect the performance of the respective indices.

Steps to Invest in ETFs

Here are the steps to invest in ETFs in India:

• Step 1: Open a Demat and Trading Account

To buy and sell ETFs, investors need a Demat account and a trading account with a stockbroker.

• Step 2: Place a Buy or Sell Order

ETFs are traded on stock exchanges like regular shares. Investors can place orders through their trading platform, specifying the quantity and price.

• Step 3: Choose Market or Limit Order

• • • Market Order: The trade executes at the prevailing market price.
    • Limit Order: The investor sets a maximum buying price or a minimum selling price. The trade executes only if this price is met.

• Step 4: Execution and Holding in Demat Account

If the order matches an available price, it gets executed. The investor’s Demat account is credited with ETF units.

• Step 5: Trading and Market Influence

The ETF’s price fluctuates based on net asset value (NAV) and demand-supply dynamics in the market. Mutual funds may act as market makers to balance liquidity.

• Step 6: New Fund Offer (NFO) Participation

Investors buy newly created ETF units during an NFO. These are then listed and traded like regular stocks.

Final Thoughts

ETFs provide a smart, flexible, and affordable means of diversifying your portfolio while reaping the advantages of trading in the stock market. Even if you are a novice or an experienced investor, knowing what is ETFs will offer scope for growth, income, and risk management. With their transparency, liquidity, and tax efficiency, they are a great addition to any investment plan. Ready to move ahead? 

Open a FREE Demat account with Torus Digital today and begin investing in ETFs with ease!