What are ETFs and should you invest in them?

People do not want to invest in mutual funds because they feel that they will lose their money to market volatility. Some do not want to invest because they are not comfortable with the fact that mutual funds have portfolio managers who actively manage and rebalance the portfolio from time to time and try to generate returns. Some investors want to be in total control of their investments and do not want them to get affected by human biases. Such investors can invest in passive funds like exchange traded funds.

What is an exchange traded fund?

Before discussing ETFs, let us understand what active and passive funds are. Mutual funds that active participation of the fund manager where he or she buys and sells securities and takes risks to favor the lucrative markets and maintain a diversified portfolio are referred to as active funds. Then there are passive funds that are designed to replicate the performance of their underlying benchmark and have very little participation from the fund managers. Exchange traded funds are one such passive fund, the other being index fund.

An exchange traded fund (ETF) is an open ended scheme whose units are available for trading at their current live market price. Just like they are in company stocks, investors can trade in ETF units. Exchange traded funds are the only type of mutual funds to be listed at the stock exchange. 

Why should you invest in ETFs?

High liquidity

Unlike some equity mutual fund schemes like ELSS (Equity Linked Savings Scheme) that comes with a statutory lock-in of three years, there is no such lock-in with ETF investments. This gives ETF investors the liberty to buy or sell their investments. This flexibility gives investors the choice the change their investments to suit their changing financial goals. Also, to buy or sell mutual fund units, investors have to request the AMC and they can buy or sell units based on the scheme’s NAV which is determined at the end of the day. However, to buy or sell ETF units investors need to not wait for so long and can enter or exist ETFs at their current live market price.

Total control over your investments

As mentioned earlier, retail investors who invest in other mutual fund schemes have to place an order request to the fund house and only then can buy or sell their ETF units. Also, when it comes to ETFs investors have total control over their invested sum as these funds replicate the performance of the underlying index. Here, the fund manager does not have any role in helping the ETF scheme generate capital appreciation, thus leaving almost no room for human error. 

Relatively low expense ratio

Since exchange traded funds do not have any active participation from the fund manager and the scheme is designed to mimic the performance of its underlying index with minimum tracking error, they have a low expense ratio. A scheme with a low expense ratio can be a good choice as in the long run, investors will end up giving away a very small percentage of their capital gains to the AMC.

Those who wish to invest in exchange traded funds must first consult their financial advisor to know whether this scheme is ideal for their financial goal. These funds are constantly exposed to market vagaries and hence conservative investors may find investing in ETFs unconvincing. Also, they should diversify their investment portfolio with other schemes as well instead of depending on just investment for their financial goals.