A. Diversification and Risk Management
One of the most appealing aspects of Exchange Traded Funds (ETFs) is their ability to provide instant diversification.
In the world of investing, diversification is the golden rule to manage risk. It’s like spreading your bets across multiple horses in a race—if one underperforms, others may still win.
ETFs allow you to invest in a basket of different assets through a single purchase.
For example;
If you invest in an ETF tracking the Nifty 50, you’re not just buying shares of one company but investing in the top 50 companies across various sectors, such as banking, IT, energy, and more.
This reduces the risk associated with relying on the performance of a single stock. If one company in the index has a bad quarter, others may compensate, helping smooth out potential losses.
Diversification through ETFs also helps reduce sector-specific risk. For instance, in 2020, the banking sector faced challenges due to the pandemic.
Investors who had only bank stocks suffered significant losses. However, those invested in a broader index ETF experienced lower losses as other sectors like pharmaceuticals and technology performed well during the same period.
Risk Management Example:
If you invest ₹10,000 in a single stock and it declines by 50%, your investment value drops to ₹5,000.
However, if you invest that same ₹10,000 in an ETF tracking multiple stocks, a 50% fall in one stock will have a much smaller impact on your overall portfolio. This is the power of diversification.
B. Cost Efficiency and Transparency
Investing in ETFs is not only about diversification but also about cost savings. ETFs are known for being more cost-effective than traditional mutual funds.
The reason is simple: most ETFs are passively managed, meaning they replicate the performance of an index rather than relying on an active fund manager.
Without the need for a highly paid manager to pick individual stocks, the cost of running an ETF is lower, and these savings are passed on to the investor.
Lower Expense Ratios
The cost efficiency of ETFs is reflected in their lower expense ratios compared to actively managed funds.
The expense ratio is the annual fee that fund houses charge investors to cover operating costs. For instance, an actively managed mutual fund might have an expense ratio of 1.5%, while an ETF may charge as low as 0.10%.
Example:
If you invest ₹1,00,000 in a mutual fund with an expense ratio of 1.5%, you’ll pay ₹1,500 annually in fees. In contrast, an ETF with an expense ratio of 0.10% would cost you just ₹100 per year.
Transparency
ETFs also offer greater transparency compared to other investment options. Since ETFs track an index, their holdings are published daily, allowing investors to see exactly what they are investing in.
This level of transparency is often lacking in actively managed mutual funds, which may only disclose their holdings quarterly.
With ETFs, there are no surprises—you know what you are buying and what assets are part of the portfolio at all times.
C. Liquidity and Trading Flexibility
Another significant benefit of ETFs is the liquidity they offer. Unlike mutual funds, which can only be traded at the end of the trading day at the Net Asset Value (NAV), ETFs can be bought and sold at any time during market hours, just like stocks.
This feature provides greater flexibility and allows investors to respond quickly to market changes.
Intraday Trading
The ability to trade ETFs intraday is especially important for active traders who may want to take advantage of short-term price movements. Suppose you’re an investor who believes that the market is going to rise during the day.
With an ETF, you can buy in the morning and sell in the afternoon if your prediction turns out to be correct, locking in profits within a single day.
Liquidity:
Liquidity refers to how easily an asset can be converted into cash without affecting its market price. ETFs are generally highly liquid because they are traded on stock exchanges.
For example:
The Nifty 50 ETF and Sensex ETF are among the most liquid ETFs in India, allowing investors to buy or sell large quantities without significantly affecting the price.
However, it’s important to note that not all ETFs are equally liquid. Some sector-specific or thematic ETFs may have lower trading volumes, which could lead to wider bid-ask spreads (the difference between the buying and selling price).
Thus, while ETFs generally offer excellent liquidity, it’s advisable to check the trading volume of a specific ETF before investing.