Everything About Investing In ETFs: 10 Key Takeaways

You want to invest in the stock market, but picking individual stocks feels overwhelming. You've heard about mutual funds, but the fees seem high. Enter ETFs – Exchange Traded Funds – a simple way to invest that's taking India by storm.

The numbers tell an impressive story. Indian ETF assets have grown eight times over the past five years, reaching INR 4 lakh crore. This growth reflects a significant shift in how Indians approach investing.

What makes ETFs special?

Think of an ETF as a basket filled with stocks that track an index like the Nifty 50. When you buy one ETF share, you own a tiny piece of all those companies. It's like buying a slice of the entire market instead of individual ingredients.

Unlike mutual funds, you trade ETFs on stock exchanges just like individual stocks. This means you can buy and sell them during market hours at real-time prices.

Why India's ETF market took time to grow

Mohanty explains that India remained a market where skilled fund managers could outperform the index, a phenomenon experts call "alpha generation." When fund managers consistently outperform the market, investors stick with actively managed funds.

"India is still a great market for alpha generation," Mohanty notes. "The shift to ETFs happens when the alpha generation ability of the market starts to diminish. We are on that cusp."

As markets mature, it becomes increasingly challenging for fund managers to outperform their respective indexes consistently. This creates demand for low-cost index tracking through exchange-traded funds (ETFs).

The 10 key takeaways for ETF investing

1. You need a Demat account

Investing in an ETF requires a Demat account, unlike mutual funds, which can be invested directly. Think of a Demat account as a digital locker for your shares. Most brokers offer demat accounts, and the process takes just a few days.

This requirement might seem like extra work, but it gives you more control. You can trade ETFs at any time during market hours, unlike mutual funds, which process orders only once daily.

2. Watch the tracking error

Tracking error measures how closely an ETF follows its underlying index. A lower tracking error means the ETF replicates the index more accurately.

For example, if the Nifty 50 rises 10% but your ETF rises only 9.5%, the tracking error is 0.5%. Higher tracking errors indicate fund inefficiency. Always check this metric before investing in an ETF.

3. Cost matters, but it's not everything

ETFs typically cost less than mutual funds. While mutual funds usually charge 1-2% annually, ETFs often charge 0.1-0.5% annually. This difference compounds over time.

However, don't choose an ETF solely based on its low costs. A slightly more expensive ETF with better tracking and liquidity might deliver better returns than a cheaper alternative with poor execution.

4. Innovation comes with a price

Fund houses create specialised ETFs based on unique investment ideas, such as sector-specific funds, thematic investments, or international exposure. These innovative ETFs may be more expensive than basic index funds.

This pricing reflects the research and expertise behind the investment strategy. Consider whether the additional cost is justified by the specialised exposure you're getting.

5. The US market offers alpha opportunities

Despite ETF growth, the US market continues to reward skilled active management. Many fund managers continue beating their benchmarks, especially in mid-cap and small-cap segments.

This creates a balanced approach opportunity. Utilise ETFs for core holdings while adding actively managed funds to capitalise on potential outperformance in specific segments.

6. Market maturity drives ETF adoption

As markets mature, generating alpha becomes harder. The US market exemplifies this – most actively managed funds underperform their respective indexes, driving massive adoption of ETFs.

India sits at this transition point. While alpha opportunities exist, they're shrinking. This trend suggests continued growth in ETFs in the years to come.

7. Overseas investment considerations

Current regulations affect new overseas investments. While existing overseas investors face no immediate concerns, new purchases require waiting for regulatory clarity to be established.

This impacts ETFs offering international exposure. Check current regulations before investing in international ETFs or funds that hold overseas assets.

8. Perfect for beginners

Mohanty recommends ETFs for first-time investors. They offer instant diversification without requiring deep market knowledge. A single Nifty 50 ETF provides exposure to India's top 50 companies.

New investors can start with broad market ETFs and then gradually explore sector-specific or thematic options as they gain experience and knowledge.

9. Goals determine exit timing

Your investment goals should dictate when you sell ETF holdings, not market conditions. If you're investing for retirement 20 years away, short-term market volatility shouldn't trigger selling decisions.

Create clear investment goals with specific timelines. This approach prevents emotional decision-making during market fluctuations.

10. Don't wait for tax breaks

Mohanty emphasises making investment decisions based on merit rather than tax incentives. Tax benefits might change, but solid investment fundamentals remain constant.

Focus on ETFs that align with your investment goals and risk tolerance. Tax efficiency should be a bonus, not the primary criterion for selection.

Investment ETF definition simplified

An investment ETF is a fund that holds a basket of securities and trades on stock exchanges, similar to individual stocks. ETFs typically track an index, commodity, bonds, or other asset baskets.

The definition encompasses both the structure (exchange-traded) and the strategy (usually passive indexing). This combination provides diversification with trading flexibility.

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Investing in index funds vs ETFs

Both index funds and ETFs offer index exposure, but they differ in trading and structure. Index funds are priced once daily after the market closes, while ETFs trade throughout market hours.

ETFs often have lower minimum investment requirements and greater trading flexibility. Index funds may offer automatic investment plans and don't require a demat account.

Choose based on your trading preferences and investment approach. Long-term investors may prefer index funds for automatic investing, while active traders may favour the flexibility of ETFs.

Getting started with ETF investing

Start by opening a Demat account with a reputable broker—research broad market ETFs like those tracking Nifty 50 or Sensex for your first investment.

Begin with small amounts to understand how ETF trading works. Monitor tracking errors, expense ratios, and liquidity before making larger investments.

As you gain confidence, explore sector-specific or thematic ETFs that align with your investment thesis. Remember to maintain diversification across different asset classes and sectors.

The ETF revolution in India has just begun. With markets maturing and alpha generation becoming challenging, ETFs offer an efficient way to participate in India's growth story. Begin with the basics, understand the fundamentals, and gradually develop a portfolio that aligns with your financial objectives.

Whether you're investing in ETFs for the first time or expanding your investment portfolio, focus on low-cost, well-diversified options that align with your long-term financial objectives. The key lies not in timing the market but in time spent in the market through consistent, disciplined investing.

Frequently asked questions about ETFs?

1) What is the 3:5-10 rule for ETF?

The 3:5-10 rule (often called the "Rule of 10, 5, 3") is a diversification guideline:

• No single investment should be more than 10% of your portfolio.

• No sector should exceed 5%.

• No single company should be more than 3%.

  This helps reduce risk by avoiding overexposure to any one asset, sector, or company.

2) What are the basics of ETF investing?

• ETFs are funds that hold a basket of assets (like stocks or bonds) and trade on exchanges like stocks.
• They offer built-in diversification, lower costs than mutual funds, and trading flexibility.
• To invest, open a brokerage or Demat account, select an ETF that aligns with your goals, and purchase shares during market hours.
• Monitor performance and rebalance as needed.

3) What is the 70/30 rule ETF?

The 70/30 rule refers to a portfolio allocation strategy:

• 70% of your portfolio is invested in stocks (for growth).

• 30% is invested in bonds (for stability).

  This mix aims to strike a balance between long-term growth and risk management, and is popular among investors seeking both safety and returns.

4) What is the key advantage of ETFs?

The key advantage of ETFs is diversification: with one purchase, you gain exposure to a broad range of assets, reducing risk compared to buying individual stocks. Other significant benefits include low fees, trading flexibility, and transparency.

Disclaimer: Investing in ETFs involves risk. Please consult a financial advisor before making any investment decisions.