ETFs: Types, advantages and disadvantages

Let's know more about ETFs: Its types, advantages and disadvantages

ETFs or exchange-traded funds are a group of curated stocks that track an index, a commodity, or a mix of assets like the index fund. ETFs have features of stocks & mutual funds in the sense that, they can be traded like a stock on the exchange on a real-time basis and they also work like mutual funds as the underlying asset comprises of a set of stocks (like NIFTY or a commodity like gold). Let us look at the various types of ETFs prevalent in the market:  

Index ETF: Most of the ETFs that exist are index ETFs. These types of funds are designed to specifically track the performance of the index (Sensex, Nifty, etc). This is done by including the entire contents of the index or simply, having a sample of securities that best represent the index. The two types of Index ETFs are called ‘replication’ and ‘representation’ ETFs. Replication Index ETFs invest entirely in the underlying securities that make up the index. Similarly, representative ETFs are funds that invest in most of the fund in representative samples and in other holdings (futures, options, etc)  

Commodity ETFs: As the name suggests, commodity ETFs are for investors, who want to invest in commodities such as gold, silver, and other precious metals. These are index funds that track the non-security indices. In fact, the first-ever commodity ETF were gold exchange-traded funds. Initially, commodity ETFs actually had the commodity itself, but nowadays, futures trading strategy is implemented.   

Bond ETFs: Bond ETFs are exchange-traded funds that generally invest in bonds. When the stock markets go through an economic recession, bond ETFs come in demand. These funds can give a reasonable yield and allow ordinary investors to gain passive exposure to benchmark bond indices in an inexpensive way.  

Pros of ETF investments:  

• Diversification: It’s easy to think of diversification in the sense of the broad market verticals i.e. stocks, bonds or a particular commodity. For example, ETFs also let investors diversify across horizontals, like industries. It would take a lot of money and effort to buy all the components of a particular basket but with the click of a button, an ETF delivers those benefits to your portfolio. 

• Transparency: Anyone with internet access can search the price activity for a particular ETF on an exchange. In addition, a fund’s holdings are disclosed each day to the public, whereas that happens monthly or quarterly with mutual funds. 

• Tax benefits: Investors typically are taxed only upon selling the investment, whereas mutual funds incur such burdens over the course of the investment. 

Cons of ETF investment:  

• Trading costs: ETF costs may not end with the expense ratio. Because ETFs are exchange-traded, they may be subject to commission fees from online brokers. Many brokers have decided to drop their ETF commissions to zero, but not all have.  

• Potential liquidity issues: As with any security, you’ll be at the whim of the current market prices when it comes time to sell but ETFs that aren’t traded as frequently can be harder to unload.