What are ETFs?
ETFs are open-ended funds that are traded on the stock exchange. They are bought and sold just like regular shares during trading hours. ETFs contain a mixture of assets such as shares, bonds and commodities. ETFs track the performance of an index.
Why use ETFs?
ETFs provide a wide range of benefits, which are:
Lower Cost – ETFs are basically a replication of defined index. They also have lower management fees than actively managed funds. ETF investing also offers lower commission fees. Unlike in independent shares purchasing, ETFs covers the entire transaction in one fee. Overall, these lower costs directly put cash in your hands.
Portfolio transparency – Investors can view anytime ETF’s current trading price its composition at any time. This provides transparency, which is useful in times of volatile market conditions. It is also helpful in creating a portfolio made of ETFs.
Tax efficiency – There is no need for a customer to interact with the ETF provider. Buyers and Sellers can trade ETF units on a stock exchange. This means that taxes such as stamp duty, exchange fees are lower.
Also, the turnover for ETF portfolio is lower than many of the actively managed funds. This means there will be fewer transactions and therefore lower taxes for ETF holders.
Liquidity – Unlike in mutual funds, where it can take a couple of days to make a portfolio, ETF investors can buy and sell at any time while the markets are open. ETFs are also measured based on Net Asset Value (NAV). The liquidity of the underlying stock reflects the liquidity of the ETF.
Diversification – ETF incorporates all qualifying securities or a representative sample. This offers lower portfolio variability and thus reduces the impact of volatile markets. Whereas, if you had bought a stock, the volatility would be a lot higher.
How can you make use of the ETF?
- Adjustments – You can shift the portfolio based on the asset class, sector or region.
- Investing fully – A corporate can maintain a fully invested portfolio of ETFs by investing the cash, as and when received from the clients.
- Portfolio rebalancing – You can also keep switching the ETF fund managers to reduce risk and also based o performance.
- Hedging – By using this strategy, you can reduce your exposure to the market without needing to sell the underlying security.
- Portfolio choice – Through ETF, you can access asset classes that were traditionally and exclusively available to only institutional traders.
- ETF covering – ETF funds are always protected from any misuse. They are regulated by the Securities and Exchange Board. It also allows redemptions at any time.
How to evaluate an ETF?
- ETF exposure – Evaluate the benefits and drawbacks of diversification and then select the desired level of exposure. You could choose a broad market ETF with extensive exposure to all sectors. Or you could also select an ETF for high performance, which focuses specifically on one industry.
- ETF access – Majority of ETFs provide returns through physical replication. Other ETFs use total return swaps. The latter gives return similar to that of what index gives. It does not involve hedging the underlying security. Investors should analyse the risk and fees associated with swap against the advantages of a swap.
- Portfolio weighting – ETF mostly targets the same segment or sector of the market. The different weighting schemes today available are market capitalisation, equal weighting and factor weighting. The choice may vary depending on asset class and preference of individual investors.
- ETF provider – While selecting whom to invest with, the following factors should be considered:
- Performance record
- Product classification
- Ability to recognise current investment trends
- Capability in industry development
- Financial stability
Investing in Equity through ETF
ETFs provide a safer investment in equity markets through a wide range of products. They are mostly classified as:
- Broad Market ETFs – It gives exposure to a wide range of companies without information about a specific industry. Covering world indices would require owing hundreds of stocks and regular portfolio rebalancing. However, an ETF investor can invest in all of these companies at a fraction of the cost. This return (after deducting fees) is much higher than when ETFs are compounded.
- Sector Specific ETFs – They invest in a more precise group of companies. The different sectors are large-cap, mid-cap, small-cap, utilities. This ETF aims to identify those microeconomic sectors which will outperform the broader market.
- Factor-based ETFs – The investments need to satisfy specific criteria and rules before they can be included in the ETF. This inclusion is a strategy in itself. So investors can benefit from this strategy without having to build a strategy of their own. Examples of such filtering factors are high dividend based, low volatility or value stocks.
Portfolio building strategies
ETFs are a valuable tool to build strategies for a portfolio. The most popular strategies using ETFs are:
- Mixing index and actively managed funds – Indexed funds offer market performance known as a beta while fund management provides alpha though sector allocation and other strategies.
- Mix core and satellite investments – The core comprises of major asset classes in order to achieve the best risk to reward. Satellites add value to the core by including those assets that are dependent on the market environment.
- Short-term tactical strategy – You can adjust your portfolio by varying exposure to a specific sector or segment in every two or three months.
Different levels of liquidity in an ETF
- The First level of liquidity – This is the natural liquidity that is created by buyers and sellers on the exchange. ETFs with transaction volumes create greater liquidity than their portfolio holding.
- The Second level of liquidity – Only participants with authorisation can bid and offer prices on the exchange. This feature enhances liquidity by allowing a buyer and seller to transact with minimum cost.
- The Third level of liquidity – ETF units are created based on the underlying stock. Participants maintain balance by creating more units when there is an increase in demand. Similarly, they redeem units when there is a decrease in demand. This is done to tighten supply.
While investing in ETFs, the underlying liquidity is what matters. The liquidity of the underlying security measures the real liquidity of an ETF. With this, you can place a lot of trade orders without manipulating the price of the ETF itself.
Investing in ETF is comparatively feasible for novice traders and investors. Because investing in other instruments like mutual funds required huge minimums to open an account.
The minimum balance required to invest in mutual funds may start from $1,000 to $2,000. So ideally, young investors won’t be able to invest in them unless they have that kind of money. Hence, comparatively, ETFs are better investment opportunities for novice traders compared to mutual funds.