Exchange-Traded Funds (ETFs)
A pooled investment security called an exchange-traded fund (ETF) functions very similarly to a mutual fund. ETFs often follow a certain sector, index, commodity, or other assets, but unlike mutual funds, they can be bought or sold on a stock exchange just like normal stocks. Anything from the price of a single commodity to a sizable and varied group of securities can be tracked by an ETF. ETFs may even be designed to follow particular investment strategies.
The first ETF was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index, and which remains an actively traded ETF today.
Unlike stocks, which only hold one underlying asset, ETFs hold a variety of underlying assets. ETFs are frequently used for diversification because they contain a variety of assets. Thus, a variety of investments, including stocks, commodities, bonds, or a combination of investments, can be found in ETFs. In comparison to mutual funds, ETFs are typically cheaper and more liquid.
Types of ETFs—
Investors have access to a variety of ETFs that can be used to manage risk in their portfolios, generate income, and engage in speculation and price appreciation, and generate income. Here is a brief summary of some of the ETFs that are currently on the market.
Passive and Active ETFs
ETFs can generally be classified as either passively managed or actively managed. The goal of passive ETFs is to mimic the performance of a larger index, whether it be a more specialized sector or trend or a more diversified index like the S&P 500.
Typically, actively managed ETFs do not aim to track an index of assets but rather have portfolio managers choose which securities to hold. Despite being more expensive for investors, these products have advantages over passive ETFs.
Bond ETFs
Investors can receive consistent income from bond ETFs. Their income distribution is based on how well the underlying bonds perform. Government bonds, corporate bonds, and municipal bonds—also known as state and local bonds—might be among them. Bond ETFs lack a maturity date like their underlying assets do. They typically trade above or below the price of the underlying bond.
Stock ETFs
Stock (equity) ETFs are a collection of stocks that track a certain sector or industry. A stock ETF, for instance, might follow equities in the automobile industry or overseas. Stock ETFs feature lower costs than stock mutual funds and don't require actual ownership of any securities.
Sector/Industry ETFs
Funds that concentrate on a particular industry or sector are known as industry or sector ETFs. For instance, an ETF for the energy sector will include businesses engaged in that industry. Industry ETFs are designed to give investors exposure to an industry's potential growth by monitoring the activity of its constituent companies.
Commodity ETFs
Contrary to what their name suggests, commodity ETFs invest in physical commodities such as agricultural goods, natural resources, and precious metals like gold or oil/gas. They first diversify a portfolio, which makes it simple to hedge downturns. It can provide a buffer during a stock market downturn. One of the greatest draws to commodity ETFs is they are highly liquid securities and can be purchased on stock exchanges.
Currency ETFs
Currency ETFs are pooled investment instruments that monitor the performance of currency pairs that combine local and foreign currencies. ETF is available for bitcoin as well. Currency ETFs are generally managed passively and track an underlying currency and its holding in a particular nation or group of nations.
Inverse ETFs
An inverse ETF is an exchange-traded fund (ETF) constructed by using various derivatives to profit from a decline in the value of an underlying benchmark. Inverse ETFs are generally considered to be highly volatile investments, as their losses typically compound daily. This makes inverse ETFs riskier than the index to which they are tied.
Leveraged ETFs
A leveraged exchange-traded fund (ETF) uses financial derivatives and debt to amplify the returns of an underlying index. Leverage is a double-edged sword meaning it can lead to significant gains, but can also lead to significant losses. While a traditional exchange-traded fund typically tracks the securities in its underlying index on a one-to-one basis, a leveraged ETF may aim for a 2:1 or 3:1 ratio.
What to Look for in an ETF
Typically, one can look for ETFs using some of the following criteria:
Volume: A person may evaluate the popularity of several funds by looking at their trading volume over a specific time period; the higher the volume, the simpler it might be to trade that fund.
Expenses: The proportion of person’s investment that goes toward administrative expenditures decreases as the expense ratio rises. While it may be tempting to always look for funds with the lowest expense ratios, occasionally more expensive funds (such as actively managed ETFs) have strong enough performance that it justifies the higher fees.
Performance: Performance is a common criterion used to compare ETFs, even if previous performance does not guarantee future results.
Holdings: Portfolios of various funds are frequently taken into account by screener tools, enabling users to compare the holdings of each potential ETF investment.
Commissions: Many ETFs are commission-free, which means that no fees is required to execute the transaction. It is still important to determine if this could be a deal-breaker.
Pros and Cons of ETFs
Taxes and ETFs
Because the majority of purchases and sales are made through exchanges and the ETF sponsor does not have to redeem shares each time an investor wants to sell or issue new shares each time an investor wants to buy, an ETF is more tax-efficient than a mutual fund.
ETF tax treatment differs on equity-oriented and non-equity-oriented ETFs. They attract Securities Transaction Tax.
Equity-oriented schemes are index ETFs and equity ETFs. In the case of ETFs held for less than a year are taxed at 15%. Where else, units held for more than a year are taxed at 10 percent, without indexation benefits.
Gold and International ETFs are treated as non-equity ETFs. ETF tax on short-term gains for less than 36 months is applicable as per the income tax slab rate. However, long-term capital gains over a year are taxable at 20% after the indexation benefit.
The Bottom Line
As an investment option, ETFs have evolved as one of the most preferred options for investors but any kind of investment depends on your investment goals and risk appetite. You need to have a thorough understanding of the risk-return ratio of every ETF. If used correctly, they can ensure humongous returns. Invest wisely.
