Understanding ETFs And Their Working

Explained: How do ETFs work? It is no secret that investing in equities has a higher potential for earning profits. Still, many investors tend to shy away from investing in them. A primary reason for that is the risk involved since stock markets could become highly unpredictable. Due to the same reason, you need to have an extremely understanding and knowledge of stock markets to know where and when to invest and diverse.

Most importantly, you should be able to keep your portfolio relevant by monitoring it constantly.

Normal investors may not have the education or time to do this. Hence funds become a great option. Of funds, ETFs are often favored by many experts. Let us understand ETFs in detail and see how beneficial it is to invest in them.

What are ETFs?

ETFs work, in most parts, like a mutual fund but is different in specific important ways. Here, too, there will be a fund manager that manages the fund by creating and maintaining the portfolio. But ETFs are traded in the stock markets, like a stock. This has certain advantages, including –

Since the fund’s unit can be sold like a stock, ETFs tend to have higher liquidity. As a result, the time that it will take for you to redeem the units to pocket the cash is also much lesser.
The unit’s price could react to economic stimuli, like with stocks. This allows you to use advanced trading and investing methods like options trading and taking long or short positions with ETF units.
This gives you updated information on how the ETF is performing and its potential for the future.

The second main difference is how ETFs’ portfolios are created.

ETF funds portfolio

Mutual funds’ portfolios may vary according to their characters and aim but mainly depend on the fund manager’s knowledge and views.

But ETFs track an index as it is.

For instance, if you invest in a Sensex ETF, the fund’s portfolio composition will be exactly similar to the composition of Sensex.

There are certain advantages and disadvantages to this.

Advantages

It ensures less intervention in your portfolio since the indexes usually stay stable. This could give you more say over your investment than with mutual funds.
Since index stocks are not picked manually, there is less chance form bias in the case of an ETF portfolio. This also gives you better control over your portfolio.
If we take the past performance of the stock markets, most mainstream stock market indexes tend to grow, despite several dips in between. But past performance need not be indicative of the future always.

Disadvantages

While most equity mutual funds try to outperform indexes, the same is not possible in ETFs since they track the indexes themselves.
Even though the funds try to track the indexes, the growth might be slightly affected by a phenomenon called tracking error. This usually occurs due to charges like expense ratio.

Expense ratio

The expense ratio is another factor where there is a difference. The expense ratio is a fee charged by the investors toward the fund’s management expenses. The lion’s share of this goes towards paying the fund manager.

But in the case of ETFs, the expense ratio is limited to making changes to the portfolio whenever there is a change in the index’s composition. As a result, there is no need for the fund manager to create a portfolio from scratch or manage one using research. Hence, the expense ratio charged by ETFs is lower than mutual funds typically charge.

ETFs are an ideal investment option if your investment horizon matches the risk and return potential ETFs have. Hence, make sure you analyze your investment goals and risks before investing in ETFs.