What are exchange-traded funds, and how do they work?

Stock market indexes are a bracket of stocks that represents the stock markets or a particular sector as a whole. Looking at the growth of the stock markets gives you a better idea of how a particular stock market or sector is performing. Stock markets in India have been experiencing overall growth even during a few downward trends, and the same is reflected in the growth of the stock market indexes, too. Both Nifty and Sensex, the two indexes that contain the top stocks in India, have grown more than 75% in the last five years, as of September end, 2022.

But how do you make use of this growth? One way to create a portfolio similar to that of the indexes. But this is often hard work and requires a significant amount of corpus. Exchange-traded funds (ETFs) are a good alternative here. Let us learn more about ETFs and examine how it works.

What are ETFs?

An ETF is a fund that tracks the composition of an Index, like the Sensex or the Nifty, to match the growth and potential of these indexes. Stock market indexes are known to reflect the overall market situation of a country. ETFs, by tracking the index, aim to take advantage of that growth.

In many ways, ETFs work similarly to a mutual fund where the money is pooled from different investors and invested in a portfolio by a fund manager. Here, the management is passive since the fund manager’s job is limited.

But at the same time, ETFs are listed on a stock exchange, and their units are bought and sold similarly to stocks. Another difference between a mutual fund and an ETF is that while most mutual funds try to outperform an index, ETF tries to merely track the same.

Types of ETFs

ETFs are not limited to equity-based ones, though. Let us explore different types of ETFs.

Index ETF

Index ETFs are the ones that we have discussed above. They follow a stock market index as it is to mirror its performance. There are ETFs that follow the bigger indexes as well as smaller sectoral indexes. For instance, an ETF that tracks the Nifty IT index will have the same portfolio composition as the index.

Gold ETF

Gold ETF is a way for investors to buy virtual and online gold. Gold ETF is an exchange-traded fund that actively tracks the current price of gold. The ETF units experience price changes according to the price changes of gold. Gold ETFs track the price of 24-carat physical gold. 

Bank ETF

Bank ETFs are also equity-based fund that tracks banking and related companies. They mostly track different banking indexes.

International ETFs

An International ETF is a way for you to invest in international securities to take advantage of the international stock market growth. For that, these ETFs track a global index. They may come with an added risk because of geopolitical reasons, but they are a good way to diversify your portfolio.

Liquid ETF

Liquid ETFs, as the name suggests, invest in the most liquid securities. This includes money market instruments and currencies. 

Conclusion

One critical reason why an ETF may work for you is the passive management style. This ensures that there is no bias from the manager. Furthermore, since the role of the fund manager is limited, the expense ratio is lower as well. A higher expense ratio could potentially eat into your earnings. This can be avoided in the case of ETFs as well.