When it comes to building an investment portfolio, investors usually diversify their portfolio with mutual funds, stocks, bonds, gold, etc. However, very few who invest in mutual funds consider investing in exchange traded funds (ETFs). This happens not because investing in exchange traded funds is risky. If you think that way, all mutual fund schemes carry risk but the reason a lot of people do not invest in ETFs is that a lot of people do not have any knowledge or deep understanding of how these funds work. ETFs are different from other mutual funds as these are passive funds that follow a passive investment strategy.
Let us find out more about exchange traded funds and also look at a few things one should keep in mind before investing in these passive funds.
What are ETFs?
Mutual funds can be largely categorized as active and passive funds. Active funds are those funds that are actively managed by the fund manager who ensures that the portfolio is balanced is able to generate returns from the prevailing market conditions. On the other hand, passive funds like exchange traded funds are designed in such a way that the fund tracks the tries to replicate the performance of its underlying benchmark or index. Passive funds build a portfolio of securities in the same way as they are in their underlying index without changing the portfolio composition.
Things to keep in mind before investing in ETFs
Listed at the stock exchange: Although ETFs are mutual funds, they are listed at the stock exchange all almost every index and can be traded just like company stocks. This is the biggest advantage that ETFs have over other mutual fund schemes is that investors can do intraday trading with their units. The live market price of the ETF is available to investors who can enter or exit ETFs end a number of times during the trading hours and benefit from the price fluctuations. This is not possible with other mutual funds as the investor must place a request to the AMC to either buy or sell their units.
You need a demat account and a trading account: Investors need a demat account and a trading account to invest in exchange traded funds. Investors need the demat account to store their bought ETF units.
There is a wide range of ETFs to choose from: Depending on their investment objective, risk tolerance, and depending on the kind of exposure they seek investors can consider investing in ETFs. There are international ETFs that invest in foreign securities, index ETFs that track a particular index to generate returns, gold ETFs that invest track the domestic price of gold, and debt ETFs that invest in debt related instruments.
Investors need to have a high risk appetite: Most ETFs like index oriented ETFs are constantly exposed to market vagaries. This makes them mutual fund schemes of a very high risk profile. Hence, only those investors who have a very high risk appetite should consider investing in them.
Investors can make a lumpsum investment or start a SIP: Those who wish to invest in ETFs can either make a lumpsum investment or opt for the Systematic Investment Plan (SIP). SIP allows investors to invest a fixed sum of their choice in any ETF scheme at periodic intervals. Investors can invest monthly, quarterly, biannually, or once a year via SIP. They can also use an online SIP calculator to compute the overall returns that their SIP investments might be able to generate after the end of their investment horizon.