Exchange traded funds or ETFs are funds which are traded on the exchange. ETFs may invest in stocks, commodities or currencies and units of these funds can be bought and sold on the exchange.
Let us consider exchange traded funds which invest in stocks. Traditional ETFs generally track a market index and they bear similarity to index mutual funds. Investing in them is as beneficial as investing in index mutual funds. The turnover of the investor will be low as he can stay invested in the ETF. This in turn reduces his costs. He is also able to diversify his investment across different sectors. One advantage over mutual funds is that the expense of investing in exchange traded fund units is even lesser than the cost of investing in mutual funds.
One can follow different investment strategies to derive the maximum benefit from exchange traded funds:
The best and proven way of making money in the stock market is by passive investing. This means that once the investor makes the investment, he holds it over a long period of time and does not try to benefit from price fluctuations by trading. By buying ETF units and holding them over the long term, one can reap the benefits of investing in a basket of stocks. Though one can have the same advantage by investing in a mutual fund, an exchange traded fund has an additional benefit. The investor can buy and sell ETF units on the exchange itself.
Though passive investing is the better option, traders cannot stay away from trying to profit from intraday and short term movements in the ETF prices. Intraday trading in mutual fund units cannot be done but exchange traded funds, by virtue of trading on the exchange provide intraday and short term traders good trading opportunities.
Today, we have many ETFs which follow investment strategies other than just tracking the index. They may copy the investment pattern of a successful mutual fund or imitate the stock picks of a good investment manager.
An ETF provides arbitrage opportunities to the fund managers. If the prices of the underlying stocks are lesser than the price of the ETF units, fund managers can buy shares of the underlying stocks and sell ETF units. Conversely, if the price of the ETF units is lower, they profit by buying ETF units and selling the underlying stocks.
In case of exchange traded funds which track market indices, the stocks in which investment is made is more or less common knowledge. However in other ETFs, disclosing the names of companies whose shares have been purchased, may result in the investor buying those shares directly from the market to save on the charges levied by the fund. So exchange traded funds generally disclose the investments made after a short time gap and that too only to investors.
People wishing to diversify their investments can invest in different kinds of exchange traded funds. There are ETFs which invest in large cap companies, others which invest in mid cap companies and some others in small cap companies. There may be ETFs which invest in infrastructure companies, in technology companies and so on.
There are many investors who do not want to restrict their investments to stocks. They want to spread their risk by investing in commodities, currencies and so on. Earlier, this was possible only by investing in the respective futures contracts. Today however, investment diversification is easy as the investor can buy units of different kinds of exchange traded funds. There are currency ETFs, funds which invest in precious metals like gold ETFs and silver ETFs. There are also commodity ETFs like oil ETF.
Investing in an exchange traded fund is the ideal investment avenue for retail investors who want to invest limited amount of funds across different investment categories.