Advantages of Exchange Traded Funds (ETFs) (2024)

An important part of evaluating any investment option or asset category is to get to know its benefits. In this article, we delve into the advantages of Exchange-Traded Funds (ETFs), which are among the lesser-known investment avenues for investors in India. If you are not sure what ETFs are, how they work and what the benefits of ETFs are, read on to find out more about these details.

What are Exchange-Traded Funds (ETFs)?

An Exchange-Traded Fund (ETF) is a type of marketable security that resembles a mutual fund but can be traded on an exchange as its name indicates. Like mutual funds, ETFs also invest in a basket of different assets. Depending on the type of assets predominantly chosen for the portfolio, ETFs may be equity-oriented, debt-oriented or even hybrid funds.

ETFs are commonly designed to track specific benchmarks and indexes in the market like the Nifty, Sensex and a whole range of other sectoral, thematic or market-cap-based indexes. They may also invest in a portfolio of bonds, commodities or other securities, depending on the index being tracked.

Advantages of ETFs

Now that you know how these investment vehicles work, let us take a closer look at the key advantages of Exchange-Traded Funds for investors.

• Liquidity
  One of the defining benefits of ETFs is that they can be easily traded on stock exchanges, just like regular equity stocks. So, you can buy ETFs or sell your ETF holdings at any time during business hours. That said, some ETFs may be less liquid than others, depending on the demand. So, you need to be mindful of the liquidity of the Exchange-Traded Funds that you have chosen to invest in and adjust your investment strategy accordingly.
• Affordability
  Another major advantage of Exchange-Traded Funds is that they are extremely cost-effective. Since they are designed to track an index, they follow the passive style of investment, which eliminates many of the costs associated with active fund management. This results in lower expense ratios for ETFs overall, so the net returns from these funds are not reduced greatly due to investment costs.
• Diversification
  Since ETFs track indexes, they offer the advantage of inherent diversification. Each index is generally a group of stocks or other securities. So, Exchange-Traded Funds have a mix of different securities in their portfolios. Achieving the same level of diversification by choosing stocks and securities individually for your investment portfolio can be cumbersome and costly too.
• Accessibility
  If you are planning to purchase ETFs, there are no minimum investment limits that you need to worry about. This leads us to the next advantage of Exchange-Traded Funds, which is that they are highly accessible to traders and investors with varying budgets and financial capacities. Also, since ETFs track different types of indexes, you can find an Exchange-Traded Fund for any kind of risk appetite.
• Hedging opportunities
  A lesser-known and lesser-used advantage of ETFs is that they also offer hedging opportunities. This is because investors can borrow these funds and short-sell them to protect against the downside risk in another long position in similar assets. Additionally, since ETFs are traded in smaller denominations when compared with other similar assets, they are suitable for investors with smaller portfolios as well.

How do ETFs work?

To better understand the advantages of Exchange-Traded Funds, you need to first have clarity about how they work. The creation of the fund’s portfolio works similarly to how mutual fund portfolios are created. However, unlike regular mutual funds, ETFs can traded like equity stocks on the bourses.

Since ETFs are structured like mutual funds, they are also taxed in the same way. This means debt-oriented ETFs are taxed like debt funds and equity-oriented ETFs are taxed like equity funds. Also, since ETFs typically track an index, they are passively managed assets. This distinct feature results in many advantages of ETFs for investors, as you will see in the following section.

Limitations of ETFs

While there are several advantages of Exchange-Traded Funds, you must also be aware of the limitations of these investment vehicles. The main downsides of ETF investments include the following:

• Tracking errors
  Since ETFs passively track indexes, they are prone to tracking errors — which occur when the ETF’s returns differ from the benchmark’s returns. While investment costs lead to marginal tracking discrepancies, you may need to take corrective action if the difference is too high.
• Potentially lower returns
  ETFs essentially follow the passive investment strategy. So, the potential to offer benchmark-beating returns is typically reduced. So, they may not be ideal for aggressive investors who want to accelerate the process of creating wealth.
• Short-term volatility
  Exchange-Traded Funds are traded on the exchanges. This means that their prices are susceptible to short-term volatility stemming from shifting supply and demand forces in the market. That said, ETF traders can capitalise on such short-term price movements.
  

Conclusion

Now that you know the advantages of ETFs, you can make an informed decision about including them in your investment portfolio. If you want to tide over the limitations of ETFs, you can also consider investing in mutual fund schemes. Check out the 1,000+ mutual funds available on the Bajaj Finserv Mutual Funds Platform to find the right fit for your goals.

You can even compare mutual funds on this platform and streamline your investment decisions using tools like a SIP calculator, which can be particularly useful if you want to make SIP investments in mutual funds.

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