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Investing Basics: Understanding ETFs

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March 27th, 2022 08:00

Understanding ETFs


Understanding ETFs is gaining significance owing to its recognition in the present time. Exchange-Traded Funds or ETFs are passive investment funds that include a basket of securities that track the market index. 

These date back to the 1990s as an investment instrument aimed at individual investors. It aimed to make investing convenient for them where they did not have to actively manage funds to get a profitable return. The use and popularity of ETFs have grown ever since as they provide, inter alia, diversification and risk management. 

Therefore, if you are looking forward to investing and wish to be passively involved in the same, ETFs might just be the match for you. Given below are a few of the considerations which could aid you to make an informed decision and help you understand ETF trading.

 

Understanding the common types of ETFs


Commodity ETFs


  • These are the ETFs in which you invest in physical commodities in various industries, including commercial, agricultural, and industrial. You won't own the product per se, but you only track its price in the market. For instance, if you invest in livestock, you do not need to house a group of cattle in your home. So, you will be entering into a series of contracts backed by the commodity.


Dividend ETFs


  • Such ETFs require you to invest in a few stocks which would give high dividends. These ETFs would provide a broader exposure to markets while having a low-risk level. So, this allows you to receive your dividend payments regularly while not trading actively.


Equity ETFs


  • If you are looking for another low-risk and low-expense investment option, then this might suit your interests. These provide transparency and flexibility of a stock market which you can buy and sell as per your market analysis.


Who should invest in an ETF?


ETFs provide diversity to your portfolio, but there are certain factors to keep in mind when making an investment in them. If you have your doubts regarding your ETF investment, you can weigh the pros and cons of the same and then decide for yourself once you understand ETF trading. 


Pros of investing in ETFs


Low risk


  • If your risk-taking capacity does not allow you to invest in mutual funds or other securities, ETFs might just be the option for you. You merely have to buy the funds and hold them for a long period without any regular active participation from your side. Hence, they offer you more stability.


Cost-efficient


  • ETFs are comparatively inexpensive because they are passively managed. They merely replicate the performance of an index and do not need to be traded actively. You do not necessarily need the services of a fund manager because they are simplistic, thereby they help save costs.


Flexible


  • You may buy and sell your ETFs as per your convenience as they are freely traded in the market. You can diversify your portfolio by investing in ETFs and make it more variant. It exposes your portfolio to different securities which you can trade as per your requirements.


Cons of investing in ETFs


Not suitable for short-term investing


  • Investing in an ETF is prudent only if you’re thinking long-term. You have to hold the securities for a while before selling them or the returns would not be significant. Therefore, if you are looking to receive returns in the short term, ETFs might not serve the purpose.


They often don’t outperform


  • Since ETFs merely emulate the performance of the market indices, there is little-to-no scope for them to outperform those. Your returns, although stable, would be limited to an extent. Hence, ETFs are more suitable for consistent and long-term returns.


With the diversified investment instruments available in the market and the increasing and varied investment needs of people, ETFs have gained momentum along the way. Hence, understanding ETF is significant for beginners venturing into the security market. They have spanned out productively and fairly well over the years and provide a comparatively safer investment tool for passive investors. ETFs however, are not risk-free. After all, they are traded in the market, the stability of which isn’t guaranteed either. Therefore, to invest in ETFs, be prepared to take some amount of risk, bear certain costs, and sit back to hold the instrument for a longer period. 


Conclusion


You do not need to be a stock market geek to invest in this instrument as it does not require comprehensive and frequent market research and analysis. You simply have to make your decision backed by your research and exercise your prudence!

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Frequently asked questions


1. What is an ETF and how does it work?

  • An ETF is a group of securities that are traded in the securities exchange. They possess the characteristics and prospective benefits of other trading instruments in the market and are traded throughout the day. 


2. How do you analyze an ETF?

  • An ETF is mostly analyzed by the fund’s expense ratio. The primary input in an ETF is the expense ratio which indicates the rate that the fund charges to do the job, i.e., tracking an index. 


3. Are ETFs worth it?

  • ETFs can prove to be fruitful for those investors who are looking forward to holding a diverse basket of securities at a relatively lower cost. These are usually traded long-term by the investors. 


4. Is now a good time to buy the ETFs?

  • While market trends impact the decision of investing in securities, ETFs are bought when the investor is looking forward to buying and holding the securities for a longer period. 


5. How does an ETF make money?

  • There are usually two types of benefits derived from an ETF, viz capital gains and dividend payments. While one affects the share price of the share held by you, the other pays money in cash.
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