Exchange Traded Funds (ETF)

What is an ETF?

An exchange traded fund (ETF) is a type of security that is similar to a stock-exchange index , because it tracks an index, sectors or commodity. However, unlike a mutual fund, it can be traded like a stock on an exchange, with prices changing as shares are bought and sold.

From an investor’s point of view, ETFs are attractive options because they provide the same kind of diversity in investment strategy, like a mutual fund does and also create the facility to purchase as little as one share, in the target industry (automobiles, textiles, etc). Generally, expense ratios for ETF’s are lower than those for most mutual funds. You have to pay a commission to purchase an ETF through a broker.

In recent times, Exchange-traded funds (ETFs) have gained wider acceptance as financial instruments. Investors are attracted to the investment avenues created by ETFs precisely because they are different from those created by mutual funds. Additionally, an investor need not be familiar with the process of picking stock or equity from a stock exchange, in order to buy into an ETF. Many mutual funds provide ETF products that attempt to replicate the indices on NSE, so as to provide returns that closely correspond to the total returns of the securities represented in the index.

Currently ETF's are available on Equity, Debt, and Gold.

The only downside to an ETF is that liquidity is poor and there is no online mode to invest. However, if you choose to set aside a sum of money for long-term investment without any financial constraints on that sum, an ETF can be an excellent option for you.

Why ETF's

There are about 2000 companies traded everyday on National Stock Exchange (NSE) and on the Bombay Stock Exchange (BSE). All these companies publish an annual report and four quarterly updates. These reports are provided so that current and potential investors can understand the financial health and direction of the company. However, it Is not easy for all investors, especially individual investors, to track and understand the financial status of publicly-traded companies. Even if the number of financial reports is brought down to the top 200 stocks, it still a humongous task. How does an investor then choose his investment targets? Here is where an ETF offers a readymade solution to invest in stocks based on Nifty50, Nextnifty50, BSE sensex and other sectoral indices. Essentially, an ETF makes it easy for small investors to access stock from the high performer companies in all industrial sectors.

Stocks (Popularly known as ‘Equities’)

What does Equity mean?

Possession of equity in a company means that an investor has a share in the ownership of the company. The extent of equity or the number of shares that are owned by the investor are determined by the amount of money invested and the value of each share of the company. If you are a small (non-institutional ) investor, owing equity in a well-established and growing company is an opportunity for financial growth.

The financial returns provided by equity investments depends on the company’s profit earnings and share prices on the stock exchanges. Investors gain from dividend spaid by the company and by selling the shares on the stock exchange if the current price is higher than the purchase price that they have paid to buy the stock. Large companies tend to be more stable than mid and small companies, hence their stock prices are relatively less volatile.

Why invest in Equity?

The inflation bug eats into the purchasing power of our hard earned money. Hence, while we save a portion of our disposable income, it becomes imperative to invest in wealth creating asset classes. Historically, equities have performed better than other asset classes over long periods of time.

Choosing stocks

Growth Or Value

Companies generally fall into one of two categories, depending on how they make money for their investors – Growth and Value.

Growth companies are in an expansion phase. Any available money they have is likely to be reinvested toward the expansion of their business or the development of new products and services. As they grow, the value of their shares, on the stock exchanges, increases.

Value companies are usually well-established businesses. While they may still be growing in terms of accruing profits, there's usually no scope for the kind of rapid expansion that growth companies pursue. So, rather than deploy all their cash flow into opportunities for development, these companies are more likely to pay dividends to investors.

Capitalization

Companies can also be categorised based on their ‘capitalization’, sometimes shortened to just ‘cap’, which is a based on total shares issued by the company. Stocks are generally considered to be large-, mid-, or small-cap, again depending on ‘Market Capitalisation’.

The distinctions between large-, mid- and small-cap companies are quite flexible and can change as the overall market value of the company changes. In general, large-cap stocks make up about 75% to 80% of the entire market, and mid- and small-cap stocks about 10% to 15% each. Stocks of the remaining companies can be put into the ‘micro-cap’ category. Such stocks are generally not an attractive option for investment because their liquidity might not be high.The stocks of large-cap companies tend to be more stable than those of smaller companies. However, smaller companies may have more potential for growth. Therefore, investors must choose from companies of different magnitudes, carefully.

Sectors

Companies can also be categorised by the industrial sector that they operate in. As with capitalization, there are several different sector classifications like financial services, banking, IT services, health care, fast-moving consumer goods (FMCG), commodities, heavy engineering and automobiles.

Stocks within particular sectors tend to react in predictable ways in response to economic conditions. Therefore, it's important to make sure your investments don't get too concentrated in specific sectors, unless you're doing it intentionally as part of your investment plan.

For example, when the economy is doing poorly, sectors like automobiles, banking , and financial services may suffer because people can choose to spend less in these areas.

On the other hand, it is usually necessary for people to spend on things like consumer staples, utilities, and health care. Hence, sectors like FMCG and healthcare may be less affected.

It's also important to note that good or bad news about a company's stock may affect other companies within that sector to some degree.