How to Benefit from Investing in ETFs?

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Exchange-traded funds are passive investments that follow specific market indices like Sensex, Nifty, and Nifty Bank. ETFs invest in a stock portfolio that closely resembles the index. In contrast to actively managed mutual fund schemes, these funds aim to reduce tracking error rather than outperform the index. The difference between an ETF and an index return is called a tracking error.

When investing in ETFs, you should expect to receive the index returns, if any, and nothing. ETFs are a fantastic investment option for novice equity investors concerned about losing money in mutual funds because, compared to standard mutual funds, ETFs have several benefits. Some of these are:

 

Lower Cost: Cost is by far ETFs' biggest advantage over actively managed funds. ETF expense ratios can be 1.5 to 2.25% lower than expense ratios for actively managed funds. Top-performing, actively managed mutual funds have previously provided investors with high alphas, but many average and below-average performers struggle to outperform the benchmark.

The cost advantage of ETFs over actively managed funds can benefit investors over long investment horizons.

 

Enhanced Diversification: The biggest benefit of an ETF is that it gives the investor wider exposure to classes of stocks, fashion trends, or market segments. ETFs can track a broader range of stocks than a single stock and even mimic country-specific returns or returns from several countries. One could, for instance, research an ETF from BRIC, which stands for Brazil, Russia, India, and China.

The ETF has lower fees and has the characteristics of any equity investment that can be easily traded.

 

Immediate Reinvestment: Dividends paid by companies in an open-ended ETF are immediately reinvested, whereas indexed mutual funds may vary in timing. It should be noted, however, that dividends generated by unit investment trust-based ETFs are not automatically reinvested. As a result, the dividend drag is created.

 

Limited Tax Exposure: ETFs are reputed to be less tax-intensive than mutual funds. This is because most capital gains tax is leviable on the sale and is solely the investor's responsibility. Compared to mutual funds, ETFs are more advantageous because any capital gains from in-kind transfers don't result in tax penalties. If securities are sold at a profit, the latter must divide all capital gains among their shareholders.

If investors in any other mutual funds sell their units before the record date, the remaining investors in that fund bear the cost of capital gains and must pay taxes even though the fund's overall value may decline.

 

Lower Discounts: ETFs are traded during regular trading hours at prices that are somewhat like the prices of the underlying securities. Thus, arbitrage restores prices to their proper range if they are noticeably higher or lower than net asset values. This differs from closed-ended index funds in that ETFs trade on demand and supply, allowing market makers to profit from price differences.

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