What is ETF?
EFT(Exchange traded funds) track a particular index, sector, commodity ,foreign market. EFTs can be purchased and sold on a stock exchange in the market hours in the the same way as stocks. The units/shares of an ETF are usually bought and sold through a stock exchange. ETFs have gained significant popularity among investors due to their diversification, higher liquidity, and ease of trading. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs, and tax benefits.
What are the benefits of ETF?
ETFs offer more convenience and liquidity to investors since they are listed on exchanges and trade like stocks. Investors can transact ETFs in any time during market hours at real time prices unlike actively managed mutual funds where NAV is computed only once a day after the market closes. Investing in ETF has all the trade combinations of investing in common stocks, including limit orders and stop-limit orders. ETFs can also be purchased on margin by borrowing money from a broker.
Short selling is also available to ETF investors. That means we can borrow securities from brokerage firm and simultaneously selling those securities on the market. The hope is that the price of the borrowed securities will drop and you can buy them back at a lower price at a later time. more over that the ETFs are already diversified within themselves. If you are investing in some of the best ETFs for a longer time you can earn a very good return. In ETFs the weak companies(companies which are not performing well) are automatically weeded out and add the best performing one instead of that means ,you are always invested in the best companies.
What is creation and redemption process in ETFs?
ETF shares are created when an “authorized participants typically a large institutional investor, such as a broker-dealers enter into a contract with an ETF, to allow it to deposit a daily “creation basket” (or cash) with the ETF. In return for the creation basket or cash , the ETF issues to the authorized participant a “creation unit,” a large block of ETF shares (generally 25,000 to 200,000 shares)
ETF shares may be redeemed through the reverse of the creation process. That is, an authorized participant presents the specified number of ETF shares to the ETF in exchange for a “redemption basket” of securities,
What are the advantages of EFTs compared to mutual funds?
ETFs and mutual funds are similar because they pool money from the investors and invest in various securities.
1) Trading flexibility
ETFs are bought and sold during the day when the markets are open. The pricing of ETF shares vary throughout the day. Thus the trading opportunities that arise during a day may be better utilized. ETF investors know within moments how much they paid to buy shares and how much they received after selling.
Any investment or redemption from a mutual fund is executed on closing NAV at the end of the day. Thus, the live trading is not possible.
ETFs can also be purchased on margin by borrowing money from a broker. It is not possible in Mutual funds
In an Index Fund, the portfolio created is exactly mirrors the index. If the Index has 50 stocks, the fund will also have those 50 stocks. MF unit’s price will be equal to that fund’s net value divided by the number of outstanding shares. Outstanding share represents the number of units of a mutual fund.
ETF is a fraction of shares in the index. For example, if an ETF is 1/100th of a benchmark index and if the index level is 19448, then one unit of the ETF will be available at Rs 194.48.
3) Expense ratio
The expense ratio of ETF is much lower than mutual funds ETFs do not need active portfolio management as they replicate the performance of the index. Hence, the the expenses associated with ETF investments are low.. The expense ratio of ETFs may come around 0.35%.
However the expense ratio of mutual funds will be around 2%.In case of mutual funds the fund manager actively takes investment decisions on behalf of the investors. Hence, the fund management expenses are higher.
ETFs are much more tax-efficient than Mutual Funds. ETFs, use creation units that allow for the purchase and sale of assets in the fund collectively. ETFs have very little turnover, so fewer capital gains than an actively managed mutual fund .Secondly, the majority of ETFs have passively managed . Here portfolio changes only when there are changes to the underlying index rather than actively selecting securities. .Mutual funds are actively managed.
Long term capital gain(hold on ETFs for more than a year )will be taxed at 10% .Holding on to ETFs for less than one full year will result in a short time capital gains of 15%..
Mutual Funds vs ETF
|ETFs can be actively bought and sold on exchanges, similar to individual stocks.
|Mutual funds only can be purchased at the end of each trading day based on a calculated price known as the net asset value(NAV)
|ETFs are typically passively managed.
|Mutual funds can be both active or passive, but most mutual funds are actively managed, meaning fund managers made decisions about how to allocate assets in the fund.
|ETF expense ratios could be as low as 0.35%.
|An active mutual fund could have expense ratio up to 2%.
|ETFs are more tax-efficient as they have a lower capital gain tax
|Mutual Funds are less tax-efficient.
|Higher liquidity ,as day trading is possible
Asset allocation with proper levels of diversification could be difficult for individual investors . ETFs provide investors with exposure to broad segments of the equity markets with low minimum investment amount. ETFs offer a wide range of investment options, including equity ETFs, bond ETFs, sector-specific ETFs, commodity ETFs, and more. Investors can choose ETFs that align with their investment goals and risk tolerance .Each ETF has its own investment strategy, risk profile, and fees, so it’s crucial to understand these factors before making any investment decisions.