ETFs: Basics & Common Myths

For over a decade, mutual funds have offered benefits like diversification, portfolio management, and convenience to retail investors who lack the required time or means to trade their investment portfolio profitably. Lately, a new sort of mutual fund has been introduced, offering almost the same benefits as conventional open-ended funds with much higher liquidity. Such funds are known as ETFs (exchange traded funds). They trade on the public exchanges and can even be purchased and sold during the market hours, like stocks.

The rise in popularity of such funds, however, has even created several misinformation regarding ETFs. Listed here is a short brief about ETFs and a few common misconceptions surrounding them.

What are ETFs?

ETFs, invest in a basket of stocks that mirror the performance of the underlying index on holding the securities in the same proportion. They are traded throughout the day at a price that differs depending upon demand and supply. The crucial point to consider is that a retail investor requires having a Demat account to sell or purchase ETFs.

What is the minimum limit of investment in an ETF?

Equity ETF: You can buy as low as just 1 unit, at per unit cost. Equity ETF has zero minimum investment limit.

Bond ETF: In bond ETF, the minimum investment can be Rs 1,000, and then in multiples of Rs 1,000.

Gold ETF: In gold ETF, the minimum investment is 1 unit.

Why should you purchase an ETF?

Investors may consider investing in ETF to avail the listed benefits:

Diversification: As ETF can track a basket of securities, investing in it provides the benefit of diversification.

Ease of trade: You can easily sell and purchase an ETF anytime during the trading session throughout the day.

Ease of transaction: As ETF is traded like stocks, the investor can place various order types.

Transparency: Maximum ETFs are indexed in nature, so their constituents are well known.

Cost efficient: ETFs have lower expenses than other investment types.

Debunking common ETF misconceptions

No. 1 myth: ETF just provide broad market exposure

Reality: While few ETFs offer a broad market exposure on tracking the broad market index like Nifty or Sensex, the ETF vertical has evolved greatly to include a broader choice of ETF. It includes pinpointed products targeting sectors (banking), narrower market indices like the midcap, assets (liquid or gold), certain rules or factors like value or low volatility.

No. 2 myth: ETFs do not pay any dividends

Reality: When the constituent stock of an ETF declares a dividend, the announced dividend is added to the ETF’s NAV, which in turn is included in the investor’s wealth.

No. 3 myth: ETFs comes with no liquidity

Reality: Illiquid ETFs were the basic concern in early 2000, at the time when ETFs were introduced. However, with market expansion and the involvement of a higher number of investors in the ETF vertical, liquidity is not a concern anymore.  Note that ETFs derive liquidity from the underlying assets. In an extreme scenario, in the situation of liquidity problems, a retail investor can approach an ETF issuer to redeem the units.

To finally conclude, ETF is one of the simplest routes to get equity market exposure. Novice or first-time investors must select a broad-based ETF to begin their journey with investments. However, the evolved investors mostly prefer investing in smart beta ETFs. Note that smart beta ETF is a fund that uses a mix of passive and active investing. It follows an approach, which is rule based for choosing investments that can be included in your fund portfolio. A smart beta usually chooses its securities depending on numerous factors like volatility expectations, the company’s dividend growth, market capitalization, and overall earnings.