Know what is an ETF, its full form and meaning. Learn about the different types of exchange traded funds and their benefits to investors.
When broken down to the atoms, all investment strategies are based on reducing risk. Pooling of funds is no different, which attempts to reduce both systematic and residual risk. One such pool of funds is ETF that we will be discussing here.
The full form of ETF is Exchange Traded Fund. Normally referred as acronym \ETF\, these are Exchange-traded funds that can traded on a stock exchange like stocks. They simply offer you the best attributes of both stocks and benefits of mutual funds too.
An Exchange Traded Fund is similar to both derivatives and mutual funds, in a lot of ways. The first aspect being that an ETF derives its value from a basket of underlying securities, often tracking an underlying index. Also, an ETF is often listed on exchanges, and can be traded throughout the day, unlike its counterpart Mutual Fund which is often traded only once after the markets close.
The idea of an ETF is basically to diversify risk, which is often the only method to reduce risk. The way an ETF does that is by basically spreading the risk across a variety of assets spanning across different companies and industries.
Effectively, this means that when you buy an ETF, every rupee is spread across the underlying index, and it is that index’s value that determines the value and growth of your investment in the ETF. Needless to say that the demand/supply effect on the security’s price is still present, but ultimately, that also depends on the aforementioned aspect.
For example, when you buy into a NIFTY ETF, every rupee spent is basically divided among the assets proportionately. In this instance, suppose you spend Rs 100. Those 100 rupees is spread across all the 50 companies in the index, Rs 10 in one company, Rs 15 in another, etc making 50 parts of that Rs 100. But there is no need for actually buying all these securities, the fund buys these and the said Rs 100 is invested in the fund, so sort of an indirect investment.
There are two types of such exchange traded funds:
One type of ETF fund is passively managed, which means the fund just buys all the securities in the index dividing the money in a particular ratio.
The other type being actively managed, where the manager and employees are actively buying and selling securities to change the ratio of assets held, but the underlying idea remains the same.
Some of the advantages of ETFs are as follows:
The first benefit is obviously diversification of risk, because if suppose one industry under performs, only that proportion of the investment sustains losses and the rest can still carry those losses and still earn a decent amount, effectively managing risk.
The second is lower costs, especially over other such pooling of funds. For example, mutual funds and hedge funds charge a high management fee for such services, of course their job entails more research because the actions are specific. Note that while actively managed ETFs have a little higher cost than passively managed ones, over a period of time, Warren Buffet points out, low cost ETFs always beat such funds’ return.