What is Exchange Traded Fund (ETFs)? Meaning, Benefits & Types

Exchange-Traded funds (ETFs) are investment funds that can be traded on stock exchanges. The funds follow the price movement of a specific index. This is a group of stocks or assets from the market or particular industry. ETFs often comprise a mixture of investments such as bonds, stocks or commodities. This makes ETFs a handy tool for investors that they can use to diversify their existing portfolio without having to buy bonds or stocks separately.

This is a style of management that is linked with mutual and exchange-traded funds (ETF) where the fund’s portfolio reflects the market index. Passive management is the right opposite of active management where the fund’s manager attempts to stay ahead of the market trends by investing in various strategies and selling/buying decisions of the portfolio’s securities. Passive management is also known as ‘passive investing’, ‘index investing’ or ‘passive strategy’.Also Read: What is Trailing Commission in Mutual Funds?

The demand and supply of the Exchange Traded Fund on the market determines the price. The trading value of the ETF is attached to the Net Asset Value (NAV) . The NAV makes up the total value of the assets managed by the ETF which is divided by the number of available shares. It is like a reference point for the price of the ETF. The trade price of the ETF differs from the NAV due to market variables and transactional costs.When an investor pays attention to the NAV and the trading price of the ETF, they can get a clearer understanding of the ETF's performance.

ETFs include different assets such as bonds, stocks, currencies or commodities.The underlying assets are managed by the fund manager who forms the fund in order to track performance and offer shares in that fund to the investors. Shareholders own part of the ETF but not the fund’s assets.Investors in the ETF track the stock index and may get lump sum dividends or reinvestments for the index’s constituent firms. Below is a quick sum up of how ETFs work

• The ETF provider takes into consideration the universe of assets such as bonds, stocks, currencies or commodities and builds a basket of them with its own ticket.
• Like a stock, the sellers and buyers trade the ETF on the exchange throughout the day.
• Investors buy the share in the basket similar to the way they would buy the stock in a firm.

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• Fixed Income ETFs: The funds are designed to provide exposure to every type of available bond
• Index ETFs: The funds are designed to track a specific index
• Commodity ETFs: The funds are designed to track the price of a commodity such as oil, gold or corn
• ETFs are created in order to provide exposure to specific industries such as medicines, high technology or oil
• Actively Managed ETFs: Unlike most ETFs which are designed to track the index, actively managed ones outperform it
• Leveraged ETFs: The funds are designed to employ leverage in order to boost returns
• Style ETFs: The funds are designed to mirror specific investment styles or market size focus such as small-cap growth or large-cap value growth
• Inverse ETFs: The funds are designed in a way to profit from a drop in the underlying index or market
• Foreign Market ETFs: The funds are designed to monitor non-Indian markets like Hong Kong’s Hang Seng Index

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ETFs are often compared with mutual funds but they trade like stocks. They have some significant advantages over other alternatives:

• Diversification An ETF provides exposure to several stock types from one industry, country, investment category, or broad market index. ETFs provide exposure to asset classes besides equities including currencies, bonds and commodities. Portfolio diversification lowers the risk of the investor. Duplicating the benefit by purchasing individual stocks is more cumbersome with respect to trading and research and likely more expensive.
• Low Fees ETFs are passively managed and so, they tend to have lower expense ratios than actively managed ones. Typically, costs such as management fees, trading expenses and fund accounting drive up the mutual fund expense ratio.
• Immediately Reinvested Dividends The dividends of the company within an open-ended ETF are reinvested immediately whereas the exact timing for reinvestment varies for index mutual funds.
• Trades Like a Stock The investor requesting the mutual fund redemption during the trading day cannot be certain of the redemption price. This depends on where the fund’s net asset value lands when calculated at the end of the day.
• Transparency The majority of ETFs need to report their holdings regularly.
• Tax Efficient They are actively managed mutual funds and generate less capital gain distributions.

Also Read: Mutual Fund Taxation for NRIs: 4 Things You Should Know

Although ETFs provide many benefits, what suits one person does not necessarily suit the needs of another. Depending on how easily you can access the funds, your comfort level with risk and how taxes come into play, you can choose ETFs. Another important point to be factored in is the time you plan to keep the money invested. All these aspects help to get an understanding if the ETF fits adequately within your overall financial strategy.