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
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
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.