Exchange Traded Funds (ETFs) have been steadily gaining popularity among Indian investors as a versatile investment instrument beyond direct stocks and mutual funds.Â
With the Indian ETF market spanning Rs. 6.5 lakh crore (extremely small when compared to the Rs. 52 lakh crore mutual fund industry), understanding the appeal and advantages of ETFs can potentially enhance portfolio construction strategies in India.
What is an ETF?
Simply put, an ETF is an instrument traded on the exchange that bundles together underlying stocks reflecting a particular index, sector, theme, or commodity. For example, units of NiftyBEES track the NIFTY 50 index stocks in proportion to the index. Globally, the famous SPY ETF mirrors the S&P 500 constituent companies.
Investment Advantages of ETFs
Diversification: ETFs provide instant exposure to hundreds of stocks, mitigating concentration risks without the need to buy each individually in optimal weights and ratios.
Liquidity: ETFs can be bought and sold in real-time on demand, like shares, as they trade on exchange. This also helps them in offering flexibility to change their holdings based on market conditions and trends.
Lower Costs: ETFs are passively managed, mirroring benchmarks, resulting in a low expense ratio (typically 0.1 to 1%) compared to actively managed mutual funds (2-3% in India), which can significantly impact long-term returns.
Global Access: ETFs allow Indian investors to participate in overseas markets, providing access to reputed tech and EV stocks abroad.
Potential Risks in ETF Investing
Tracking Error: ETF performance may slightly deviate from underlying index values due to fees and replication techniques.
Trading Premiums: Lack of adequate liquidity for less popular commodities or theme ETFs can lead to units trading extremely expensive, and decreased liquidity might lead to risky exits.Â
Counterparty Risks: ETF issuers going bust pose a threat to investor holdings, although tighter regulations are addressing vulnerabilities.
When and How Should One Use an ETF While constructing a Portfolio
Core-Satellite Approach: ETFs allow investors to adopt a core-satellite approach, where a diversified ETF forms the core of the portfolio, supplemented by satellite holdings of individual stocks or actively managed funds for strategy exposure and the creation of alpha.
Efficient Market Exposure: ETFs provide efficient exposure to specific markets or sectors, allowing investors to implement targeted investment strategies with ease. As an ETF can be sector specific as well it lets the investor take advantage by offering all the companies in that sector in a pre fixed ratio. If an investor is bullish on a theme but isn't sure on a specific stock he or she can but the ETF of that particular sector.Â
Portfolio Stability: The diversification offered by ETFs enhances portfolio stability, reducing the impact of individual stock or sector volatility.
Dynamic Portfolio Management: ETFs enable dynamic portfolio management, allowing investors to adjust their exposure to various asset classes or sectors based on market conditions and investment objectives.
In conclusion, ETFs serve as a compelling investment instrument for both beginners and sophisticated or experienced investors, offering inherent advantages such as diversification, liquidity, and low costs.Â
By incorporating ETFs into their investment portfolios, investors can enhance portfolio stability and dynamism while efficiently accessing global markets and sectors. However, it's essential for investors to evaluate the potential risks associated with ETF investing and make informed decisions based on their risk tolerance and investment objectives.
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