InvestorQ : What are the benefits of trading in ETFs?
Katherine Gonsalves made post

What are the benefits of trading in ETFs?

Arti Chavan answered.
3 years ago

ETFs or Exchange Traded Funds are closed ended funds for a fixed term which are listed and traded actively on the bourses. Normally, ETFs are used to create replicas of the index like the Nifty, Sensex or of commodities like gold, silver, oil etc. In India ETFs are yet to take off in a big way but then ETFs have been quite active in areas like indexing, commodities although the AUM is still quite small. ETFs can be bought and sold in the market like shares and they can be held as credits in your regular demat account.

What are the key benefits of an ETF?

ETFs are a form of mutual funds and hence most of the benefits of a mutual fund are available in the case of ETFs too. However, in an ETF, you can also look forward to the following additional advantages.

· Like in the case of mutual funds, ETFs also provide investors broad diversification, professional management, relative low cost, and daily liquidity

· In fact, the interesting point is that the Exchange-traded funds (ETFs) can take the benefits of mutual fund investing to the next level. ETFs can offer lower operating costs compared to traditional open-end funds, flexible trading, greater transparency, and better tax efficiency in taxable accounts. Of course, one can argue that there are drawbacks like trading costs and learning complexities of the product. However, it is apparent that the merits of ETFs overshadow the demerits by a sizable margin.

There are other positive aspects of ETFs too. For example, ETFs have several advantages over traditional open-end funds. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs, and tax benefits. Let us look at each of these benefits in detail, specifically with reference to regular mutual funds.

Trading flexibility

Traditional open-end mutual fund shares are traded only once per day after the markets close. All trading is done with the mutual fund company that issues the units. Investors must wait until the end of the day when the fund net asset value (NAV) is announced before knowing what price they paid for new shares when buying that day and the price they will receive for shares they sold that day. Once-per-day trading is fine for most long-term investors, but some people require greater flexibility. That is where ETFs offer an advantage. ETFs are bought and sold during the day when the markets are open in the same way as stocks. The pricing of ETF shares is continuous during normal exchange hours. Share prices vary throughout the day, based mainly on the changing intraday value of the underlying assets in the fund. The instantaneous trading of ETF shares makes intraday management of a portfolio much easier. It is easy to move money between specific asset classes, such as stocks, bonds, or commodities. Investors can get their allocation into the investments they want very quickly and then change their allocation.

The trade order flexibility of ETFs gives investors the added benefit of timely and flexible investment decisions. Investing in ETF shares has all the trade combinations of investing in common stocks, including limit orders and stop-limit orders. ETFs can also be purchased on margin by borrowing money from a broker. Short selling is also available to ETF investors, although in the Indian context, it can only be done on an intraday basis and not beyond that. The hope is that the price of the borrowed securities will drop during the day and you can buy them back at a lower price later.

Portfolio diversification

The second big benefit that ETFs offer is the benefit of portfolio diversification. Investors may wish to quickly gain portfolio exposure to specific sectors, styles, industries, or countries but do not have expertise in those areas. Given the wide variety of sector, style, industry, and country categories available, ETF shares may be able to provide an investor easy exposure to a specific desired market segment. Of course, in India the choice is still quite limited but that choice should build over time. Globally, you have ETFs on virtually every major asset class, commodity, and currency in the world. Moreover, innovative new ETF structures embody a particular investment or trading strategy. For example, through ETFs an investor can buy or sell stock market volatility or invest on a continuous basis in the highest yielding currencies in the world. There are also negative ETFs or Short ETFs where in you benefit from falling markets. There is also a risk reduction aspect to ETFs. For example, in certain situations an investor may have significant risk in a particular sector but cannot diversify that risk because of restrictions or taxes. In that case, the person can short an industry-sector ETF or buy an ETF that is (1-sector) on the fund.

Lower costs

Operating expenses are incurred by all managed funds regardless of the structure. Those costs include, but are not limited to, portfolio management fees, custody costs, administrative expenses, marketing expenses, and distribution. Costs historically have been very important in forecasting returns. The lower the cost of investing in a fund the higher the expected return for that fund. ETF operation costs can be streamlined compared to open-end mutual funds. Lower costs are a result of client service–related expenses being passed on to the brokerage firms that hold the exchange-traded securities in customer accounts. ETFs have lower expenses in monthly statements, notifications, and transfers. Open-end funds are required to send statements to shareholders on a regular basis. Not so with ETFs. In the case of ETFs, fund sponsors are required to provide that information only to authorized participants who are the direct owners of creation units. Individual investors buy and sell individual shares of like stocks through brokerage firms, and the brokerage firm becomes responsible for servicing those investors, not ETFs.