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Exchange Traded Funds (ETFs): Types, Features & Limitations

  • Ashesh Anand
  • Dec 01, 2021
Exchange Traded Funds (ETFs): Types, Features & Limitations title banner

An ETF, or exchange-traded fund, is a type of stock that can also be referred to as a basket of securities that trade on the stock market. Exchange-traded funds pool the financial resources of numerous people and utilize them to buy a variety of tradable monetary assets such as stocks, bonds, and derivatives. 

 

The Securities and Exchange Board of India regulates the majority of ETFs (SEBI). It's a good option for those who don't know much about the stock market.


 

Types of ETFs

 

Investors can choose from a variety of ETFs that can be used to generate income, speculate on price gains, and hedge or partially offset risk in their portfolios. Here's a rundown of some of the most popular ETFs on the market right now.

 

  1. Bonds ETFs

 

Bond ETFs are utilized to offer investors a steady stream of income. The distribution of their earnings is determined by the performance of the underlying bonds

 

Government bonds, corporate bonds, and state and local bonds, often known as municipal bonds, are examples. Bond ETFs, unlike their underlying assets, do not have a set maturity date. They usually trade at a discount or premium to the actual bond price.

 

 

  1. Stocks ETFs

 

Stock ETFs are a collection of stocks that track a specific industry or sector. A stock ETF might, for example, track automotive or international stocks. 

 

The goal is to provide diverse exposure to a particular industry, one that comprises both high-performing companies and newcomers with growth potential. Stock ETFs, unlike stock mutual funds, have cheaper costs and do not require actual stock ownership.

 

( Must Read: Understanding Key Differences Between Stocks & Bonds )

 

 

  1. Industry ETFs

 

ETFs that focus on a single industry or sector are known as industry or sector ETFs. Companies operating in the energy industry, for example, will be included in an energy sector ETF. 

 

Industry ETFs are designed to provide exposure to an industry's upside potential by following the performance of companies in that sector. One example is the IT sector, which has seen a recent flood of capital. 

 

At the same hand, because ETFs do not involve direct ownership of shares, the downside of erratic stock performance is also limited. During economic cycles, industry ETFs are also utilised to move in and out of sectors.

 

 

  1. Commodity ETFs

 

Commodity ETFs, as their name suggests, invest in commodities such as crude oil or gold. Commodity ETFs have a number of advantages. They first diversify a portfolio, making it easier to hedge against market downturns. 

 

Commodity ETFs, for example, can act as a safety net in the event of a stock market downturn. Second, owning shares in a commodity ETF is less expensive than owning the commodity itself. This is due to the fact that the former does not require insurance or storage.

 

( Do you Know, Even Blockchain has its own ETF? Read More about Blockchain ETFs )

 

 

  1. Currency ETFs

 

Currency exchange-traded funds (ETFs) are pooled investment vehicles that monitor the performance of currency pairs that include both domestic and foreign currencies. Currency exchange-traded funds (ETFs) have a variety of uses. 

 

They can be used to speculate on currency prices based on a country's political and economic trends. Importers and exporters use them to diversify their portfolios or as a hedge against volatility in the FX markets. Some of them are also employed as a form of inflation protection. Bitcoin even has its own exchange-traded fund - Bitcoin (ETF)
 

 

  1. Inverse ETFs

 

By shorting equities, inverse ETFs try to profit from stock falls. Shorting is the act of selling stock and then repurchasing it at a cheaper price, anticipating a price drop. To short a stock, an inverse ETF employs derivatives. They are, in essence, wagers on the market's downfall. 

 

When the market falls, the value of an inverse ETF rises proportionately. Many inverse ETFs are exchange-traded notes (ETNs), not actual ETFs, as investors should be aware. An ETN is similar to a bond, but it trades like a stock and is backed by a bank. Check with your broker to see if an ETN is a good fit for your investment strategy.

 

Watch this: The Pros and Cons of Exchange-Traded Funds (ETF)




 

Features of ETFs

 

  • Liquidity

 

ETFs can be bought and sold on stock exchanges at any time of day, however, some funds are more popular than others. The easier it is to find a willing seller or buyer for a fund that is traded on a regular basis.

 

  • Lower costs

 

Compared to typical mutual funds, ETFs have substantially lower expense ratios. Because ETF shareholders are not required to pay for the team of managers, analysts, and brokers that trade funds on their behalf or manage the fund's inflows and outflows, this is the case.

 

  • Transparency

 

Unlike mutual funds, which are only required to reveal their holdings every three months, ETFs are required to report their holdings and NAV on a daily basis for both open-ended and closed-ended schemes.

 

Watch this: ETFs Explained | Video 1 of ETF Education Series




 

Limitations of ETFs

 

ETFs have several drawbacks that you should be aware of before investing in an ETF trading firm.

 

  • Brokerage fees and a Demat account

 

Because ETFs are traded like stocks, there are a number of costs associated with purchasing them. The fund managers are usually in charge of this, and they charge a small commission fee for such transactions.

 

You can also choose to trade on the stock market on your own, without the assistance of a fund manager. In such a case, a Demat account must be opened. Operating a Demat account necessitates a basic understanding of stock market transactions and related techniques, which can be challenging for a newbie.

 

( If you are a Beginner interested in Stock Market Investing, Check this out )

 

 

  • The stock market's volatility

 

ETFs registered on a stock exchange are prone to price changes based on market movements. They aren't as secure as government bonds. The stock market conditions have a big impact on whether you make money or lose money.

 

 

  • Diversification

 

ETFs have a reasonable level of diversification. Because most ETFs are passively managed, they tend to invest in the best-performing businesses on a certain stock exchange. Smaller companies with a lot of potential are sometimes overlooked by ETFs.

 


 

Market impact of ETFs

 

Many new funds have been launched as ETFs have grown in popularity among investors, resulting in low trading volumes for some of them. As a result, investors may find it difficult to buy and sell shares of a low-volume ETF.

 

Concerns have been raised concerning ETFs' impact on the market and whether their popularity can inflate stock prices and cause fragile bubbles. Some ETFs use portfolio models that haven't been validated in varied market conditions, which might result in large inflows and outflows from the funds, putting market stability at risk.

 

Since the financial crisis, ETFs have played a significant role in market volatility and flash crashes. ETF issues had a major role in the flash crashes and market drops that occurred in May 2010, August 2015, and February 2018.
 

Liked the concept of an ETF? Explore the Concept of ETF Dividends too. 
 

We would like to conclude by stating that you should read both the short prospectus and the full prospectus before investing in an ETF since they contain thorough information on the ETF's investment objective, major investment methods, risks, fees, and historical performance (if any). 

 

Search engines on the internet can assist you in locating a specific ETF prospectus. Prospectuses are also available through your broker or on the websites of the financial firms that sponsor a certain ETF.

 

Don't put money into something you don't comprehend. If you can't explain the investment opportunity in a few words and in a way that everyone can comprehend, you might want to reconsider making the investment.

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