ETFs or exchange traded funds may not have appeared until recently, but they have quickly found their place with more and more takers in different markets. In India, ETF trading nearly doubled in just one year, from 1.54 lakh crore INR at the start of FY21 to 2.9 crore LAkh at the end of FY21 These funds offer many advantages over traditional mutual funds. However, before joining the ETF movement, it is important to understand ETFs and how to include them in a portfolio.

ETFs have become the next level of mutual funds, adding a few more advantages. They can be thought of as passive mutual funds that track benchmarks like Nifty. However, unlike traditional funds, ETFs are traded on an exchange. Where mutual funds can only be traded once per day when the stock market closes and only by the issuing company, ETFs are traded throughout the day on the stock markets.

Types of ETFs to consider investing in

ETFs have become a popular investment due to their trading flexibility, greater transparency, lower costs, and tax advantages, making them a suitable investment avenue in 2022. They also provide exposure to more diversified risks. But before we start, let’s find out more about the different types of ETFs.

Equity ETFs

As the name suggests, equity ETFs track stocks or market indices in a particular industry. They usually reflect the performance of popular stock indexes such as Nifty or Sensex. They can be classified based on factors, market capitalization and sectors.

Factor-based equity ETFs track factor indices created through active stock selection. Market capitalization ETFs track indices that measure the performance of companies based on their market capitalization. Sector or thematic ETFs track an index made up of securities from different sectors, but follow the same theme.

Liquid ETF

They are passive ETFs that follow overnight rates as a benchmark. These funds invest in money market instruments or short-term instruments. Hence, they have high liquidity with low risk returns. They are suitable for those who wish to place their money in the market for the short term, usually between two investments.

Commodity ETFs

These ETFs are passively managed funds that track an underlying commodity market index, such as gold or silver. Gold is one of the most popular commodities in this case, as it is seen as a stable alternative in a volatile market. Gold prices are also easier to follow.

Debt / Bond ETF

Debt ETFs offer the flexibility of investing in the stock market with the benefits of investing in debt. These are actively traded on the NSE spot market. Debt ETFs have a lower expense ratio than mutual funds.

ETF Fund of Funds (FoF)

FoFs follow other mutual funds and invest in ETFs from different asset management companies. FoFs can be selected according to the previous classifications, i.e. liquids, raw materials or equity.

What to consider when investing in ETFs in 2022

When investing in ETFs, there are some factors you should consider, such as:

Index or underlying asset

Like any investment, the value of an ETF comes from the underlying instrument or asset. So, the first step would be to choose the market in which you want to invest. Then decide if you want to invest in a benchmark as a whole or by theme / sector. To ensure risk diversification, it is always advisable to opt for a widely followed index that offers a good mix of options.

Assets under management (AUM)

Assets under management are calculated by multiplying the outstanding shares by the market price per share. The value of an ETF asset fluctuates depending on the evolution of the underlying security and the creation or redemption of shares. Typically, ETFs will display a discount or premium based on the difference between their market capitalization and the NAV (net asset value) of the underlying security. A large AUM will also generally have higher liquidity.

Total expense ratio

Think of it as the annual management fee you pay the fund company to cover its expenses. It is billed as a percentage of the overall investment. So, if the expense ratio is 0.25%, the expense ratio will be INR 25 for every INR 10,000 invested in the fund. A high expense ratio adds to the cost of the portfolio and hence it is important to factor it into your calculations.

Liquidity

Since ETFs are traded throughout the day, they offer much better liquidity options than mutual funds. ETFs with high liquidity have a smaller bid-ask spread and are therefore often preferred over ETFs with lower liquidity which have a high bid-ask spread. In other words, ETFs with low liquidity will be more difficult to sell.

Tracking error

This is the difference between the returns of the ETF and the Underlying Index. It also reflects how well the ETF tracks the index. It is obviously preferable to go for ETFs with minimal tracking error.

Final result

With high liquidity, risk diversification, low spending, and a straightforward trading system, it’s no surprise that ETFs have grown in popularity in a very short period of time. As they recover, ETFs will further widen their asset level, leading to more liquidity. Not only will this benefit the investor, but it can also fuel the growth of the economy.


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