Exchange Traded Funds - essentials of investing in ETF's

Mutual funds are an investment vehicle that allows retail investors to generate long term capital appreciation by investing in a basket of securities. Through mutual funds, retail investors can invest across various asset classes like equity, debt, gold, etc. as well in money market instruments. One can even get exposure to sectors and markets of various geographies through mutual funds. Different mutual funds have different fund management styles and investors can get diversification by investing in both active and passive funds.

Mutual funds which try to outperform their underlying benchmark and generate capital appreciation through active portfolio management are referred to as actively managed funds. Similarly, mutual funds which try to replicate their performance with minimum tracking error are referred to as passive mutual funds. Exchange Traded Funds are mutual fund schemes that follow a passive investing strategy.

What is an Exchange Traded Fund?

As per AMFI (Association of Mutual Funds in India) –

An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. In simple terms, ETFs are funds that track indexes such as CNX Nifty or BSE Sensex, etc. When you buy shares/units of an ETF, you are buying shares/units of a portfolio that tracks the yield and return of its native index. The main difference between ETFs and other types of index funds is that ETFs don't try to outperform their corresponding index, but simply replicate the performance of the Index. They don't try to beat the market, they try to be the market.

While one can invest in mutual funds without opening a demat account, investors need a demat account to trade in ETF units. Exchange traded funds are available for trading at their current market price, unlike other mutual funds whose NAV is determined at the end of the day. They are listed on almost every stock exchange.

Essentials for investing in Exchange Traded Funds

Investors can trade with ETF units daily during market hours. Aspiring ETF investors must be aware of the following facts:

- They need to open a trading account with a SEBI registered broker
- As mentioned earlier, they must also open a demat account so that they can park the ETF units bought

In order to open the trading account and a demat account, investors need to be KYC compliant. Know your customer is a one-time mandate which all investors must comply with in order to invest in mutual funds like ETFs. A KYC form demands investors to fill in basic details like their name, age, gender, residential address, etc. Along with the KYC investors need to produce the following documents:

- Document displaying Identity proof: Driving License, Passport, PAN Card
- Document displaying address proof: Utility Bill, Passport
- Bank Account Details: Bank Account Statement

Once you complete all the pre-investment formalities and become KYC compliant, you can now trade exchange traded funds units and buy/sell using the trading account.

To invest in Exchange Traded Funds investors can:

- Trade their ETF units through the broker by making a personal phone call to their broker and place the order of buying / selling units verbally.
- Or, they can use the online trading platform or an online trading app made available by their broker and place their trade orders online. As mentioned earlier, please ensure that you choose a broker who is registered with SEBI (Securities and Exchange Board of India).

Why invest in exchange traded funds?

One can diversify their investment portfolio with ETFs: Exchange traded funds are traded like stocks. By investing in a single ETF scheme investors get access to a diversified basket of securities. ETFs reduce concentration risk by investing in a wide range of securities. If they wish to seek exposure to international securities investors can consider international ETFs.

ETF investments offer transparency: An exchange traded fund tracks its underlying benchmark/index. Passive management makes it easier for the investor to track the performance of their ETF investments.

Low expense ratio: Like most passive funds, ETFs have a low expense ratio. This makes them a cost efficient investment tool and might help investors earn better long term capital appreciation.

No lock-in period: Exchange traded funds do not have a lock-in period that allows the investor to enter or exit their ETF investments at any given time. They offer liquidity to one’s investment portfolio as some investors invest in schemes like ELSS (Equity Linked Savings Scheme) that come with a mandatory lock-in of three years.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.