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Who Should Invest In Exchange Traded Funds (etfs)?

By Author: Shashank Pawar
Total Articles: 9

ETFs are a low cost, low risk and convenient way to experience equity investing and offer liquidity just like stocks. While you need a DMAT account to trade in ETFs, ETFs are not just another way of investing in stocks because they offer much more diversity by offering the entire list of stocks that make up a benchmark index. ETFs are suitable for those who can manage their investments and have a fair understanding of the financial markets.

Exchange Traded Funds (ETFs) have gained popularity among retail investors in the current decade for several reasons. But you must evaluate the suitability of investing in an ETF in the context of your overall portfolio before you jump the gun. ETFs are a low cost and low risk means to gain exposure to the stock market. ETFs also offer liquidity and real-time settlement since they are listed on the exchange and trade just like stocks.

As compared to direct equity investing i.e investing in stocks, ETFs are definitely a low-risk option as they replicate a stock index and offer diversification as opposed to investing in few stocks of your choice. We all know that an index is a fair representation of a market and comprises of market leaders from various sectors or industries. While you may be lucky in selecting some of the bluechip stocks for your portfolio at a particular time, these bluechip stocks may fall out of favor over the long term for various reasons. For instances, business models change, management teams change and new industries emerge in an economy over time. Your stock portfolio will start underperforming if you don’t keep up with the changing times.
However, the advantage with an ETF is that it mirrors an index by holding the same stocks in the same proportion as held by the index. Since indices are rebalanced from time to time to remove stocks that are no longer the true leaders in their segment and to include new leaders, an ETF automatically helps you keep pace with the underlying index and offers you a better return over a longer period.

ETFs also have lower management expenses since they don’t require active management like mutual funds. ETFs also experience lower transaction and capital gains tax since they are essentially a basket of securities trading in the market while mutual funds have to pay taxes on gains made in the portfolio they hold due to their regular buying and selling of securities.

ETFs offer flexibility in the way you wish to trade like selling short or buying on margin. ETFs also provide access to a host of alternative investment options like investing in commodities, foreign currencies, and international securities. You can also use options and futures for hedging your position which is not available with mutual fund investing.

But an ETF may not be suitable for every investor and an index fund could be a better option for new investors who want to experience the benefits of equity investing through a low-risk option for the long term. Just like ETFs, Index Funds also mimic a popular index but they function like any other mutual fund. Index funds offer the advantage of dividend reinvestment and SIPs both of which are good features of equity mutual fund investing aimed at fulfilling long-term goals like retirement planning.

Also, choosing the right ETF requires more understanding of the financial market than what most retail investors possess. You need a bit of hands-on investment style to manage your ETF investments. ETF investing can give a better return in the short to medium term i.e in the 1-3 yrs time frame but actively managed mutual funds are likely to produce a higher return in the long run. The reason actively managed funds can show better results over long time periods is because the fund manager has the flexibility to choose value stocks that are not part of the index but hold promising future potential for growth.

If you are someone who likes to take a low risk while investing and has limited knowledge of the financial market, an index fund that mimics a popular market index could be the safest option. While the fund will hold the same stocks as held by the underlying index, it will not give you the same returns as given by the index since both ETFs and Index Funds have some tracking error i.e they bear some costs while rebalancing their portfolio to mimic the holding of the benchmark index. Index funds will always have a higher tracking error as compared to ETF funds and if cost is your only concern then you should go with an ETF. But if long-term investment is your objective, you can go with an Index Fund and start a SIP to benefit from the power of compounding.

To learn more about what is an ETF Investment and related topics on Index Funds, you must visit Mutual Funds Sahi Hai, an investor education website launched by the mutual fund industry body of India i.e AMFI.

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