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What is an exchange-traded fund, how do they work, and how to select the best ETF to invest in?

What is an exchange-traded fund, how do they work, and how to select the best ETF to invest in?

An Exchange Traded Fund (ETF) is a basket of securities that trades on the stock exchange as a single unit. Typically, an ETF is a pooled investment like a mutual fund, with investors having the option to buy a share of a portfolio that either mimics an index (a passive ETF) or has an actively-managed portfolio.Here is how an ETF is created: Say an asset management company decides to start a Nifty ETF, whose mandate is to mirror the returns of the Indian benchmark index. The company raises funds from interested investors through a new fund offer (NFO), which is then deployed to buy stocks in the same proportion as in the Nifty to track the index’s return. The ETF allocates investors a unit of this portfolio proportionate to their share in the fund size. The ETF is then listed on the exchange after which existing investors can sell their units and fresh investors can come in.ETFs offer investors several advantages. The biggest ones are the option to buy a basket of securities in a single transaction, at a low transaction cost and a low entry price. ETFs also offer investors an easy method to take exposure to niche investment themes. There are also actively-managed ETFs, which do not track an index. Instead, they will have a customised portfolio created by a fund manager with the aim of beating the index.In fact, ETFs do not only invest in stocks. Their underlying portfolios may contain exposure to various asset classes: bonds, commodities, or even exotic securities made from derivatives etc.Companies that manage ETFs charge an annual fee, also called an expense ratio, for managing and operating the ETF.Features and benefitsInvesting in an ETF has many benefits. Below are some.

There are many types of ETFs. ETFs tracking the performance of an index (say Nifty) or a commodity (for instance, gold) are commonplace. There are also sectoral ETFs, which track the performance of indexes of various sectors. In developed markets, ETFs are used to track various asset classes (for example, bonds) and themes (say, companies that work in the artificial intelligence area).ETFs are traded on the stock market during regular trading hours. You can have intra-day data of price movements, analysis, highs and lows, and so on.How to choose an ETFThe first step to buying an ETF is to understand your investment needed and the risk you are willing to take. This will determine what kind of ETF you will invest in (equity vs debt, active vs passive, diversified vs concentrated portfolio).Once you have decided what you want, there are two things you should always consider.Liquidity: Some ETFs may be available at low prices but there may be little trading taking place in them. If you want to exit your position, you may not find enough buyers. Such ETFs can prove to be risky.ExpenseRatio: Your return from ETF investments is impacted by the expense ratio -- the cost of running the ETF. All things equal, you should opt for the ETF with the lowest expense ratio.Best ETFs to invest inAs mentioned above, before deciding what are the 'best' ETFs to invest in, the investor must be clear on their asset allocation.For the investor who do not have the time and inclination to research, passively-managed index ETFs are a good way to go. Active investors can follow the below strategy.

For actively-managed ETFs, you should take into account several factors. Some of these are the thinking behind the core strategy, the asset management company that manages the ETF, and the people running it. Besides, look at how the ETF has performed in various cycles, especially during market falls. Also, take into account liquidity. Finally, check whether the fund manager/company has skin in the game. That is, whether they have invested their own capital.Keeping these things in mind will help you invest in ETFs that create wealth for you. As with all things investing, patience is the key.

By

Kristal Advisors

July 21, 2021

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