Understanding ETFs (2024)

An ETF is a basket of securities that is traded on the stock exchange, just like a stock. So, ETFs are listed on a recognised stock exchange. Their units can be bought and sold directly on the exchange, through a stockbroker during the trading hours. ETFs can be either close-ended or open-ended. Open-ended ETFs can issue fresh units to investors even post the new fund offer stage.ETFs can be either actively or passively managed. In an actively-managed ETF, the objective is to outperform the benchmark index. On the contrary, a passively-managed ETF attempts to replicate the performance of a designated benchmark index. Hence it invests in the same stocks, which comprise its benchmark index and in the same weightage. For example, Nifty BeES is a passively managed ETF with the S&P CNX Nifty being its designated benchmark index.

When you buy or sell a stock, you are basing your transaction on the predicted performance of one company. When you buy or sell an ETF, you are basing your transaction on the predicted performance of multiple companies.When you buy or sell an index, you are actually buying shares in individual companies. With an ETF, you are buying shares in a portfolio of those companies. So, if you had an opinion about a certain company in the index basket, you could make an adjustment by selling or buying shares of an individual equity (although, this is not common). With an ETF, you cannot adjust the individual equities in the portfolio.

ETF units are continuously created and redeemed based on investor demand. Investors may use ETFs for investment, trading or arbitrage. The price of the ETF tracks the value of the underlying index. This provides an opportunity to investors to compare the value of underlying index against the price of the ETF units prevailing on the stock exchange. If the value of the underlying index is higher than the price of the ETF, the investors may redeem the units to the asset management company that sponsors the ETF in exchange for the higher priced securities. Conversely, if the price of the underlying securities is lower than the ETF, the investors may create ETF units by depositing the lower-priced securities. This arbitrage mechanism eliminates the problem associated with closed-end mutual funds viz. the premium or discount to the NAV.

ETFs are not MFs

You may get confused between ETFs and conventional mutual funds. However, they are different on several counts. The only similarity between ETFs and conventional mutual funds is that they both provide you an opportunity to invest in a variety of stocks/instruments through a single instrument.

When you invest in a mutual fund, you need to buy and sell units from the fund house. Since buying and selling of ETFs is done on the stock exchange, the transaction has to be routed through a broker. If ever you can buy or redeem units in an ETF through the fund house, it is normally done in a pre-defined lot size. Typically, the lot size tends to be substantial making it feasible only for institutional investors and high networth individuals.

Since ETFs are traded on the stock exchange, they can be bought and sold at any time during market hours like a stock. This is known as ‘real time pricing’. In contrast, mutual funds can be bought and redeemed only at the relevant NAV; the NAV is declared only once at the end of the day. As a result, you have the opportunity to make the most of intra-day volatility in case of ETFs. This may not hold much significance if you are a long-term investor.

Mutual funds are always available at end-of-day NAV, whereas ETFs do not necessarily trade at the NAV of their underlying portfolio. In fact, the market price of an ETF is determined by the demand and supply of its units, which in turn is driven by the value of its underlying portfolio. But in case of a close-ended ETF the price remains fixed. Therefore, the possibility of an ETF trading below (at a discount) or above (at a premium) its NAV does exist.

Understanding ETFs (2024)


Understanding ETFs? ›

ETFs or "exchange-traded funds" are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure, while helping to diversify your portfolio.

Are ETFs good for beginners? ›

Exchange-traded funds (ETFs) are ideal for beginning investors due to their many benefits, which include low expense ratios, instant diversification, and a multitude of investment choices. Unlike some mutual funds, they also tend to have low investing thresholds, so you don't have to be ultra-rich to get started.

What is ETF basics for beginners? ›

What is an ETF? An exchange-traded fund, or ETF, allows investors to buy many stocks or bonds at once. Investors buy shares of ETFs, and the money is used to invest according to a certain objective. For example, if you buy an S&P 500 ETF, your money will be invested in the 500 companies in that index.

How do you make money from an ETF? ›

How do ETFs make money for investors?
  1. Interest distributions if the ETF invests in bonds.
  2. Dividend. + read full definition distributions if the ETF invests in stocks that pay dividends.
  3. Capital gains distributions if the ETF sells an investment. + read full definition for more than it paid.
Sep 25, 2023

What is the best way to explain ETF? ›

An exchange-traded fund, or ETF, is a basket of investments like stocks or bonds. Exchange-traded funds let you invest in lots of securities all at once, and ETFs often have lower fees than other types of funds. ETFs are traded more easily too. But like any financial product, ETFs aren't a one-size-fits-all solution.

What is the downside to an ETF? ›

For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

What do you actually own when you buy an ETF? ›

There is no transfer of ownership because investors buy a share of the fund, which owns the shares of the underlying companies. Unlike mutual funds, ETF share prices are determined throughout the day. A mutual fund trades only once a day after market close.

How many ETFs should I own as a beginner? ›

Experts agree that for most personal investors, a portfolio comprising 5 to 10 ETFs is perfect in terms of diversification.

How much should a beginner invest in ETF? ›

Exchange-traded funds are similar to mutual funds in that they hold a collection of stocks and bonds in a single fund. Unlike mutual funds, they are bought and sold on stock exchanges, can be traded anytime the exchange is open, and you can start your ETF investing even if all you have to invest is $50.

Do you pay taxes on ETFs if you don't sell? ›

At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.

Do I have to pay taxes on ETFs? ›

Dividends and interest payments from ETFs are taxed similarly to income from the underlying stocks or bonds inside them. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. 2 If you earn a profit by selling an ETF, they are taxed like the underlying stocks or bonds as well.

Can you cash out ETFs? ›

In order to withdraw from an exchange traded fund, you need to give your online broker or ETF platform an instruction to sell. ETFs offer guaranteed liquidity – you don't have to wait for a buyer or a seller.

How much money should I put in an ETF? ›

You expose your portfolio to much higher risk with sector ETFs, so you should use them sparingly, but investing 5% to 10% of your total portfolio assets may be appropriate. If you want to be highly conservative, don't use these at all.

Should I just put my money in ETF? ›

If you're looking for an easy solution to investing, ETFs can be an excellent choice. ETFs typically offer a diversified allocation to whatever you're investing in (stocks, bonds or both). You want to beat most investors, even the pros, with little effort.

Is it better to invest in stocks or ETFs? ›

Stock-picking offers an advantage over exchange-traded funds (ETFs) when there is a wide dispersion of returns from the mean. Exchange-traded funds (ETFs) offer advantages over stocks when the return from stocks in the sector has a narrow dispersion around the mean.

How to tell if an ETF is good? ›

The three things you want to look for are:
  1. The fund's liquidity.
  2. Its bid/ask spread.
  3. Its tendency to trade in line with its true net asset value.

How much should a beginner invest in ETFs? ›

Exchange-traded funds are similar to mutual funds in that they hold a collection of stocks and bonds in a single fund. Unlike mutual funds, they are bought and sold on stock exchanges, can be traded anytime the exchange is open, and you can start your ETF investing even if all you have to invest is $50.

What is the first ETF I should buy? ›

List of 10 Best ETFs for Beginners
TickerFundExpense Ratio
VTIVanguard Total Stock Market ETF0.03%
QQQInvesco QQQ Trust0.20%
IJRiShares Core S&P Small Cap ETF0.06%
VXUSVanguard Total International Stock Index0.07%
6 more rows

How much money do you need to start an ETF? ›

How Much Does It Cost to Start an ETF? $100,000 to $500,000 for SEC regulation costs. The lower end is for plain-vanilla funds that don't stray from the basic strategy of mimicking a single large-cap index. About $2.5 million to seed the ETF with initial purchases of assets.


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