Exchange Traded Funds (ETFs)

All you need to know about Exchange Traded Funds (ETFs)

We live in a fast world. Everything happens at a snap and tap of a finger. As our lifestyle evolved so did our consumption style. It’s the era of the famous 2-in-1 products or services and it’s not breaking news why we love them so much. Costs less and serves multiple purposes, what more can we ask for? Right from our minty toothpaste, sunscreen- moisturizer, convertible bags, sofa cum beds to hoodies with Bluetooth. The list goes on and on.

Even our financial market was not left behind. It hopped on this trend with something called Exchange Traded Funds or ETFs. It brings together the best of both- Mutual funds & Stocks. In the last decade, ETFs have gained popularity for all the right reasons, so let’s understand what’s so captivating about them.

What are Exchange Traded Funds (ETFs)?

An ETF is a fund that invests in various financial assets, and it can be traded on a stock exchange like a stock. An ETF holds assets like stocks, bonds, currencies, or commodities. ETFs are listed on stock exchanges so you can buy and sell an ETF like any other listed stock. There are several categories under ETFs like Index ETFs, Equity ETFs, Gold ETFs, Debt ETFs, and even International ETFs. The NAV of an ETF changes as per market movements. The flexibility of ETFs allows you to trade in the short term or hold them for the long term. You are free to buy as many units as you wish during normal trading hours

Things to be Considered

a) Risk

ETF brings a good amount of diversification to your portfolio. Hence, the risk associated is lower than owning a stock or investing in an actively managed mutual fund for the long term. If your investment horizon is for the short term (less than a year) then it will be subject to market volatility and have a higher risk. So, in that case, you must have a better understanding of stock markets.

b) Trading Costs

Since ETFs can be bought and sold like any stock on a stock exchange, they attract brokerage charges. ETFs have trading costs or charges associated every time you take a trade position. So, if you take frequent trade positions in an ETF as you do while trading in stocks it may not prove to be as cost-effective. Also, make sure that the ETF you are dealing with has good trading volume for liquidity concerns

c) Dividends/ Interests

ETF issuers are required to pay Dividends/interest earned on assets to their investors in proportion to their respective holding. The issuer can either distribute such earnings in cash or can reinvest the same amount to buy additional units of the same ETF. The choice is up to the issuer. Hence, it is crucial to find out what an ETF is offering before investing.

d) Tax

Dividend distribution tax is applicable as per your income tax slab rates from the financial year 2020- 21. Tax on capital gains differs for various categories under ETFs. In the case of Equity ETFs, tax is charged as applicable to an equity mutual fund. In the case of Debt ETFs, Gold ETFs, and International ETFs, tax is charged as applicable to a debt mutual fund.

ETF's VS Mutual Funds

Who should invest?

Demand for ETFs has been slowly gaining momentum in the past few years. Adding a few passively managed ETFs could prove to be a good mix in your portfolio. It can bring diversification and minimize the risk factor of your portfolio. Hence, investors who are interested in creating wealth with a long-term investment horizon and low-risk appetite can consider investing in this instrument. It is also a good low-cost option for young investors.

Bottomline

Whether you hold an ETF for the long term or short term depends on your financial goals, and risk appetite. Investors must recognize their financial goals and risk appetite in order to make a fully informed investment decision. There are different categories of ETFs available in the market, catering to different risk appetite and investment horizon to meet the needs of different investors. It is wise to weigh the pros and cons of all the options available to achieve your investment goal optimally. ETFs are an affordable way to diversify your portfolio with the added benefit of professional portfolio management.

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