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What are Exchange-Traded Funds and What to Do with Them?

May 17, 2019 | 1 year ago | Read Time: 4 minutes | By iKnowledge Team

Exchange Traded Funds

The efficient-market hypothesis is a theory in financial economics, which implies that it is impossible to “beat the market” consistently on a risk-adjusted basis as outperforming strategies are quickly imitated and arbitraged away. Hence in the long run, simply investing in the whole market passively tends to outmatch active asset picking. If you believe in this theory, exchange-traded funds (ETFs) are the ideal investment product for you. An ETF, which is a type of a passively managed fund, generates returns in line with a benchmark index by replicating its portfolio. The underlying portfolio may represent an index, securities or commodities. Exchange-traded funds offer the flexibility of a stock and protection of a fund which can be easily bought or sold anytime during market hours, just like any other stock on the exchange. Apart from being liquid, ETFs are also generally cheaper than actively managed funds due to their significantly lower expense ratios and brokerage commissions.

Types of ETFs

Given the surge of popularity of exchange-traded funds in India, it’s vital to track these funds as they come to market. The following list of ETF types in India will help you make the most informed decisions possible, in order to determine which, one makes the most sense for your investment goals:

  1. Commodity ETF: Commodity ETF invests in commodities such as precious metals and crude oil futures. In India, we only have Gold ETF which typically hold physical gold as the underlying asset.
  2. Bond ETF: These ETFs might include government bonds or treasuries, corporate bonds, and state and local bonds—called municipal bonds. There is currently only one such exchange-traded fund is available in India, i.e. Liquid BeES.
  3. Index ETF: Index ETF is actually index funds that hold and keep certain securities and attempt to duplicate the performance of a stock market index. An index fund’s main objective is to track the performance of an index – whether benchmark or industry-specific such as banking – by holding in its portfolio either through a selection of the securities in the index or by replicating the contents of the index entirely.

ETF Creation and Redemption

The key to understanding how an exchange-traded fund works and how its supply is regulated lies in the “creation/redemption” mechanism. The process of creation/redemption involves a few large specialized investors, known as authorized participants (APs). APs are large financial institutions with a high degree of buying power, such as banks or investment companies. Only APs can create or redeem units of an ETF. When creation takes place, an AP assembles the required portfolio of underlying assets and turns that basket over to the fund in exchange for newly created ETF shares. For instance, if an ETF is designed to track the Nifty 500 index, the AP will buy shares in all the Nifty 500 constituents in the exact same weights as the index, then deliver those shares to the ETF provider. Similarly, for redemptions, APs return ETF shares to the fund and receive the basket consisting of the underlying portfolio. Each day, the fund’s underlying holdings are disclosed to the public.

Basically, to ensure the ETF has the same value as the asset it represents, investors will make the supply curve shift by creating or redeeming the ETF. Creating the ETF means increasing supply, shifting the curve to the right and decreasing the price. Redeeming the ETF means reducing the supply, shifting the curve to the left and increasing price.

Advantages and Disadvantages of Exchange Traded Funds

Just like any other investment product, exchange-traded funds have certain advantages as well as limitations when compared to other products. Among the key benefits of ETFs is the overall lower cost. In India, ETFs provide lower average costs since it would be expensive for an investor to buy all the stocks held in an ETF portfolio individually and pay brokerage commission for each transaction.

Moreover, the expense ratio of an ETF is usually less than one-fourth of an actively managed equity fund, reducing costs for investors even further. Since an exchange-traded fund can be bought and sold at any time during trading hours, it is also more liquid than an ordinary mutual fund. ETF also carry inherent transparency as you know beforehand which securities or commodity it will hold and in what proportion. And since ETFs do not rely on active investment calls by a fund manager, it is not affected by human errors and miscalculations.

However, as risk-free and stable ETFs may be, you may be giving up the potential to outperform the broader market as you are only passively tracking the index. An actively managed fund can not only give you the index return but also beat it. Additionally, in the case of index-oriented exchange-traded funds, usually, only mature companies make it to indices like the Nifty 50 or Sensex. Many of these companies have put their best years of growth behind them and you might miss the pockets of growth in the mid- or small-cap market.

Investing in ETFs

To invest in exchange-traded funds, all you need to have is a demat account and an online trading account. Usually,  pan card, identity proof and address proof are required to open a demat and trading account. Once you have got the accounts ready it is just a matter of choosing an ETF and placing the order online from your broker’s trading portal. The orders are routed to the exchange where the purchase order is matched with the sell orders and executed.

To sum up, ETFs are a great way to get started with investing. They are fairly simple to buy and understand, they will help you diversify your portfolio and they do not require much capital. In addition, ETFs are a great way to expose yourself to a certain industry or market which you think may do well. Lastly, remember that investing is a long-term game – so be patient and keep saving.

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