Understanding ETFs: Types, Benefits, and Strategies

The investing world can be intimidating for newcomers, filled with complex jargon and seemingly endless options. But fear not, intrepid investor! 

Did you know that the global AUM of the ETF market increased from $75 billion in 2021 to $82 billion in 2022, according to data published by Mirae? Exchange-traded funds, or ETFs, have seen a rapid increase in popularity, but for many novice investors, the world of ETFs is still full of confusing terminology. 

Let’s explain why a beginner investor should consider investing in ETFs.

What Are ETFs?

Exchange-traded Funds or ETFs, are a type of investment fund traded on a stock exchange. They can also be used to track particular stock investment strategies. Investors can use various exchange-traded funds (ETFs) to generate income, speculate, buy up stocks, and reduce or partially offset portfolio risk. 

Like a mutual fund, an exchange-traded fund (ETF) combines money from numerous participants and uses it to buy various assets, including stocks, bonds, and commodities.

ETFs have a special feature that distinguishes them from mutual funds: they may be traded all day, just like individual stocks. But what distinguishes them from traditional mutual funds?

Key Difference Between ETFs and Mutual Funds

Features	ETFs	Mutual Funds
Trading	Throughout the day	End of trading day
Liquidity	High	Lower
Costs	Lower Expense Ratios	Higher Expense Ratios

How Do ETFs Work?

ETFs operate with a unique structure:

• Pooling Investments

Similar to other investment funds, ETFs collect money from several investors. 

• Underlying Assets

This pooled money is used to purchase assets that reflect a particular index, such as the Nifty 50 or a sector-specific index.

• Sampling

Not every ETF that tracks an index owns every asset in the index. Rather, they build a portfolio that closely replicates the index’s performance using a sampling approach.

• Market Makers

ETFs include market makers, who are usually big brokerage firms, to guarantee liquidity. These market makers can issue and redeem sizable blocks of ETF shares to keep supply and demand in check and the market price near the NAV of the ETF.

Types of ETFs

ETFs are as varied as a busy marketplace in India. They serve various market niches, which reflects the wide range of accessible investment alternatives. ETFs can be roughly categorized into a number of groups based on the asset type they concentrate on: 

• Sector ETFs

These exchange-traded funds (ETFs) concentrate on particular economic sectors, including financial services, healthcare, and technology. They allow investors to finance an industry without owning individual stocks. 

If you think India’s technology sector will expand, investing in a tech sector exchange-traded fund (ETF) may be a wise choice.

• Commodity ETFs

Commodity exchange-traded Funds (ETFs) provide exposure to various physical commodities, like gold, silver, crude oil, and agricultural products. By investing in these ETFs, you can profit from price changes without owning the commodities.

• Bond ETFs

Through their bond investments, these ETFs offer exposure to the fixed-income market. They provide investors with an easy option to expand their bond holdings without purchasing individual bonds.

• International ETFs

By giving investors access to outside markets, these exchange-traded funds (ETFs) enable portfolio diversification beyond Indian markets. As a safeguard against the volatility of domestic markets, an international exchange-traded fund (ETF) may provide exposure to the United States or European stock markets.

• Thematic ETFs

Thematic exchange-traded funds (ETFs) are focused on particular themes or trends, including e-commerce, artificial intelligence, or sustainable energy. Investors can get exposure to sectors or businesses they think will outperform the overall market in the long run by purchasing these exchange-traded funds (ETFs).

With the range of ETFs available, investors can create a portfolio that fits their interests, investing goals, and risk tolerance.

• Bitcoin ETFs

In 2024, the SEC approved the spot Bitcoin ETF. By allowing investors to purchase and hold bitcoins as the underlying asset and purchase fund shares, these exchange-traded funds (ETFs) expose investors to fluctuations in the price of bitcoin in their traditional brokerage accounts. 

Exchange-traded funds (ETFs) based on futures contracts listed on the Chicago Mercantile Exchange were approved in 2021 and designed to track bitcoin futures contracts’ price movements. 

• Inverse ETFs

Profit from stock declines by selling stocks short. Shorting involves borrowing a stock, selling it while anticipating a drop in value, and then buying it back at a reduced cost.

An inverse ETF uses derivatives to short a stock. Inverse ETFs are exchange-traded notes (ETNs), not true ETFs. An ETN is a bond that trades like a stock & is backed by an issuer, such as a bank.

• Leveraged ETFs

ETFs with leverage aim to yield higher returns than the underlying investment’s return.

Benefits of ETFs

Buying exchange-traded funds (ETFs) has several advantages, much like a buffet offers a diverse range of dishes. These include-  

• Diversification

By giving investors immediate access to a diverse portfolio of assets, exchange-traded funds (ETFs) mitigate the risk of owning individual stocks or bonds. You should always remember that diversification is key to a healthy portfolio! (As the saying goes, “Don’t put all your eggs in one basket.”)

• Liquidity

Because they are exchange-traded, ETFs have better liquidity. Throughout the trading day, you can buy or sell them, giving you more freedom in managing your money.

• Transparency

Unlike certain actively managed funds, ETFs make daily holding disclosures. This transparency allows investors to precisely understand the foundation of their investments.

• Lower Costs

ETFs often have lower expense ratios than actively managed mutual funds. In the long run, this results in significant cost savings.

• Flexibility

Investors can use a variety of stock investment tactics with ETFs, including buying on margin or short selling. However, these tactics entail some inherent dangers and require a more thorough comprehension of the market.

Strategies Before Investing in ETFs

If you have been thinking of investing in ETFs, then it becomes essential to learn some of the best stock investment strategies that will help you make the right decision- 

• Asset Allocation

This strategy prioritizes diversification across asset types, such as equities, bonds, and commodities. ETFs are ideal for this strategy because of their built-in diversity. 

To achieve a balanced risk profile, you can allocate a piece of your portfolio to an ETF that tracks the entire market, such as an S&P 500 tracker, and another portion to an ETF that tracks bonds.

• Dollar-Cost Averaging

This approach is setting aside a certain amount of money each month to invest in the ETF of your choice, regardless of the price. This approach helps you average out the cost per unit over time, which reduces the impact of market volatility. 

It is a great way to build a position gradually and instill discipline in your investment habits.

• Swing Trading

Swing trading using ETFs can be an alternative for individuals who are comfortable making short-term trades (lasting a few days or weeks). ETFs are a good fit for this strategy since they provide benefits such as diversification and tight bid-ask spreads. 

To profit from price fluctuations in a sector you are somewhat knowledgeable with, such as technology, you can select an ETF based on that area.

• Short Selling

Certain sectors exhibit predictable seasonal trends, which ETFs allow you to capitalize on. For example, historically, U.S. equities tend to underperform from May to October. 

You could short a broad market ETF during this period and close the position later to potentially profit from the weakness. Remember, seasonal trends aren’t guaranteed, so using stop-loss orders is crucial.

• Betting on Seasonal Trends

The goal of short selling is to borrow money, sell it, and then buy it back at a reduced price because there is less chance of a short squeeze when shorting ETFs than shorting individual equities, even if shorting ETFs is still dangerous. 

On the other hand, novices ought to stay away from riskier choices like leveraged inverse ETFs.

Conclusion

ETFs offer a compelling option for beginners. They provide diversification, transparency, and cost-effectiveness, all wrapped in a conveniently tradable package. By comprehending the various ETF varieties and utilizing tactics such as asset allocation and dollar-cost averaging, you can design an ETF investment scheme corresponding to your objectives and risk appetite. 

Thus, make the first move, investigate the fascinating world of exchange-traded funds, and start down the path to financial success!