What is ETF and its types? Explain ETF and Top popular ETF that is better than FD

An ETF, or Exchange-Traded Fund, is a versatile investment option that combines the advantages of diversification and liquidity. An ETF is a collection of assets, such as stocks, bonds or commodities, that investors can buy and sell on the stock exchange throughout the day. Investors generally choose to invest in an ETF with the objective of tracking any particular index or sector of the market. As such, by purchasing a single ETF, investors can gain exposure to a greater segment of the market through diversification. ETFs come in many options, including tracking broad market indices, sectors of the economy, bonds, commodities, and international markets. ETFs can also be an effective alternative to Fixed Deposits when saving for the long-term as they generally have a longer-term objective that can lead to overall growth. Investors may consider an ETF that focuses on larger, more stable companies, or dividends, for those companies that pay dividends. ETFs can be less risky than a Fixed Deposit and while risk does exist and fluctuations of the general market may occur, ETFs potentially provide a higher yield than Fixed Deposits.

What is ETF?

An ETF or exchange-traded fund is an investment fund that is traded on an exchange, similar to individual stocks. The fund represents a combination of assets (such as bonds, stocks, or commodities) and seeks to replicate the performance of a specific index, commodities, asset class, or sector. ETFs are attractive investments because of their diversification abilities/benefits, low costs, and liquidity.

How ETFs Work?

Suppose you want to invest in the entire Indian stock market, but purchasing a share in each and every one of those companies would be extremely expensive and unmanageable. Here is where an Exchange-Traded Fund (ETF) plays a part. You can think of an ETF as a premade “market basket” that gets set up and managed by a large financial institution. For instance, a Nifty 50 ETF, is a basket that holds a little slice of all 50 companies in the Nifty index, in the exact same proportion. If a person buys one single unit of this Nifty 50 ETF, they are not buying one share in each company, but a small share of this entire basket. That is the fundamental purpose of an ETF: to aggregate funds from investors like you, to come together and buy a diversified portfolio of assets all at once.

So, how do you go about buying this “basket”? This is the “Exchange-Traded” part. Once the basket is created, ETF units are exchanged on a stock exchange like those of Reliance or TCS. Therefore, you could use your demat and trading accounts to buy/sell ETF units any time during the day. The price of the ETF unit will change minute-by-minute just like any stock based on supply and demand. For example, if the whole Nifty 50 Index goes up 1% on any particular day, then the price of your Nifty 50 ETF unit should also increase by approximately 1%. This offers you real-time pricing, and you are finally allowed to liquidate your investment immediately; which is not available with traditional mutual funds priced at the end of business day.

An important way that ETF price stays well in line with the actual value of the assets in the basket is through large financial firms, called “Authorized Participants” (APs). When the ETF unit starts trading for less than the price of the stocks in the basket, for example, these APs can buy a lot of ETF units on the exchange and immediately swap those ETF units with the ETF provider for the actual underlying stocks, which they can sell for a small profit. This process is called “creation”. It also works in reverse (called “redemption”) when the ETF unit is trading above the value of the stocks in the basket. This arbitrage mechanism is an invisible hand keeping the price you pay for an ETF unit in the marketplace close enough to the true net value of the contents of the ETF that it is an efficient and safe way to get market exposure.

Types of ETFs

Equity ETFs:

An Equity ETF is a category of Exchange-Traded Fund in which the “basket” contains only stocks, or ownership shares of publicly traded companies, not some other asset class such as bonds, or gold. Equity ETF have the singular goal of reproducing the performance of a specific stock market index. An index is merely a measuring instrument which tracks the performance of an assigned group of stocks.

• For example, A Nifty 50 ETF is a fund that tracks the Nifty 50 index, investing in the same 50 stocks in the same proportion. When you buy units of this ETF, you’re essentially buying a small piece of all 50 stocks. The value of your ETF units will generally move in line with the Nifty 50 index, allowing you to gain broad market exposure without having to buy individual stocks. This makes it an easy and affordable way to invest in the stock market.

Bond ETFs:

A Bond ETF is a type of fund that invests in bonds, which are loans made to the government or companies. When you buy a bond, you are lending money and will receive payments as interest, and your principal back at maturity. A Bond ETF allows you to invest in a pooled portfolio of many bond investments from various issuers, creating investment diversification and, thus, less risk for your principal and interest payments. By purchasing a Bond ETF, you are investing in a bond fund that includes many different borrowers. Bond ETFs provide easier exposure to the bond market and add more diversification.

• For example, An ETF (exchange-traded fund) that focuses on investing solely in government bonds typically holds a diversified portfolio of government bonds with different terms to maturity. When you purchase a unit of an ETF, you own a small share of that diversified investment. The ETF receives interest on the various bonds in the portfolio and distributes the interest to its investors, which can provide a steady income stream for investors. An ETF’s price will rise as interest rates fall and will fall when rates rise. Bond ETFs help investors earn regular income without taking too much risk. They provide liquidity investors want from an investment that supplies regular income, which is why they are such a popular investment vehicle.

Sector/Industry ETFs:

Sector ETFs enables you to focus your investments on a narrower slice of the economy, such as: Technology, Healthcare, Energy. Instead of investing in the entire market, you can invest an entire sector or industry. This type of ETF invests in companies in the sector we are targeting as a sector ETF. Therefore, you can gain targeted exposure to all the companies in a particular sector and their potential for future growth. You can choose to invest in sectors that you think will perform well in the future.

• For example, Nifty IT ETF allows you to invest in the technology sector in India, which includes TCS, Infosys, and Wipro. When you buy the ETF, you have exposure to the performance of the sector, which reduces the risk of investing in one name versus another. If the technology sector experiences growth, your ETF will likely experience an increase in value. Likewise, if the technology sector encounters challenges, the value of your ETF will likely fall. Sector ETFs are great options for investors who have a belief in the growth of a particular sector and want to take advantage of that without investing in each specific company.

Commodity ETFs:

A Commodity ETF allows for investing in the physical commodities you might typically buy silver, gold, wheat, oil, etc. without the physical ownership and storage of these commodities. The fund house buys and stores the commodity securely, or it might be invested in contracts tied to the price of the commodity, even an ETF based on a commodity index. When you buy units of the ETF, you own a claim on the value of the physical commodity. You can gain exposure to the commodity’s price movements without the burden of ownership, as you could simply buy and sell ETF shares on the stock exchange.

• For example, A Gold ETF lets you invest in gold without buying physical gold. The ETF holds gold in a vault, and each unit you buy represents a small amount of gold. If the gold price rises, the value of your ETF units will also rise, allowing you to profit. Gold ETFs provide an easy, low-cost way to invest in gold or other commodities like silver or oil, without the hassle of storage or ownership. This helps you diversify your portfolio or hedge against economic uncertainty.

Currency ETFs:

A Currency ETF allows you to invest in currencies from countries other than India (INR). Instead of making foreign currency purchases directly, you purchase an ETF, which tracks a specific currency or a basket of currencies that enables you to speculate or hedge on foreign exchange fluctuations. If you think a foreign currency will strengthen against the rupee, you would buy the ETF. Conversely, if you think INR will strengthen against the foreign currency, the ETF’s value will decline. Currency ETFs allow you to make currency bets without having to deal with the complexity of the forex market.

• For example, Suppose you expect the US Dollar to appreciate against the Indian Rupee. Instead of selling your rupees and buying dollars, you could purchase a USD INR ETF through your stock brokerage account, which is equivalent to buying US Dollars since the ETF holds US Dollars. When you purchase units of the USD INR ETF, you are purchasing exposure to the dollar. If the dollar increases in value against the rupee, the value of your ETF units will also increase, which means you can deposit more rupees when you sell the ETF units and make a profit. Currency exchange rate ETFs are helpful if you have an upcoming international spending obligation, are trying to hedge some currency risk, or trade forex while remaining in the stock market.

International ETFs:

An International ETF allows you to invest in the stocks and bonds of companies and governments located outside your home country. An international ETF is based on, and tracks, an index in a foreign market. They allow you to gain economic exposure and participate in the growth of other nations, without navigating the complexities of foreign investing. This can also help you diversify your portfolio by reducing your reliance on the economy of one country. If your domestic market is slowing, outside regions can help balance the overall performance of your portfolio. Investing in international equities allows you to diversify your risk, and participate in the growth of economies in the world.

• For example, An investor in India might invest in a US S&P 500 ETF that holds shares in the 500 largest US companies like Apple, Microsoft and so on. When you purchase this ETF, you will be a small owner of those lead companies. The value of your investment will rise and fall with the US stock market. There are also ETFs specific to a sector such as the NASDAQ 100, which is focused on tech with the largest companies in that sector, or you could invest in an ETF that is focused on Europe with its largest companies in Germany, France and the UK. International ETFs give you the ability to invest in growth around the world, lessen your risk of local economic downturns and be involved in industries that aren’t well represented by India. You can do all of this through your local trading account.

Inverse ETFs:

An Inverse ETF is a type of Exchange-Traded Fund that is structurally developed to make a profit as the underlying index or asset loses value. Essentially, it’s a way for you to make a gain while the market is deteriorating. Inverse ETFs use financial engineering in the form of derivatives and futures contracts to bet against the market direction. For every 1% of decline in the target index, the Inverse ETF is designed to respond with a corresponding gain, typically 1%. Inverse ETFs are typically characterized as high risk, and they have particular appeal to investors who have a strong belief that a segment of the market is about to experience a downturn without incorporating strategies like short selling.

• For example, If you believe that banking stocks will underperform because of negative loans or interest rates rising, then you could purchase a Bank Nifty Inverse ETF. If Bank Nifty falls by 5%, then this ETF will have an objective of rising by about 5% as well.

Leveraged ETFs:

A Leveraged ETF is a sophisticated and often dangerous financial instrument meant to increase the daily returns of an underlying index. These instruments can create a multiplied return on the underlying index’s performance by utilizing financial derivatives such as futures and options and by borrowing capital. The most common type of Leveraged ETF is a “2x” or “3x” ETF, implying the goal of selling returns equal to roughly 2 or 3 times the daily percentage movement of the index being tracked. This multiplication works both ways; gains become larger on the way up, as do losses on the way down.

• For example, If you place your money in this ETF, and the Nifty 50 index increases by 2% in one day, the ETF is structured to provide a return of approximately 4% (2 x 2%) for that day. Conversely, if the Nifty 50 decreases by 2%, the ETF would decline by approximately 4%.

Thematic ETFs:

A Thematic ETF is a type of Exchange-Traded Fund that is made up of investments in a basket of companies directly related to a long-term future trend or theme, rather than just being classified by the sectors we came to know. Using one of the traditional sectors as an example, a Sector ETF would be focused on the current banking or technology then Thematic ETF would be based on a forward-looking story that could cross multiple sectors.

Thematic ETFs aim to find transformative transitions in the global economy, society, or technology before it becomes the mainstream. The intent of a Thematic ETF is to captured a trend growth by investing in companies that Thematic ETF believe will be beneficiaries of that structural change, regardless of that classification in their current industry.

• For example,
  • Artificial Intelligence (AI) ETF: This theme invests in companies that are central to the development and application of AI. The basket could include tech giants creating AI software, semiconductor companies designing high-power chips for AI processing, and cloud computing firms that provide the necessary infrastructure.
  • Electric Vehicles (EV) ETF: This ETF wouldn’t just hold car manufacturers. It would create a basket of companies involved in the entire EV ecosystem, including battery makers, lithium miners, charging station providers, and semiconductor firms that produce chips for electric cars. This theme cuts across the Automobile, Materials, and Technology sectors.
  • ESG (Environmental, Social, and Governance) ETF: This theme focuses on companies that are leaders in sustainable and ethical practices. The ETF would include businesses from various sectors like renewable energy, green infrastructure, and companies with strong governance records, while excluding those involved in fossil fuels or tobacco.

Balanced ETFs:

A Balanced ETF (Asset Allocation ETF) is a single fund that provides a pre-mixed portfolio of growth-oriented assets (stocks) and income-oriented and stable assets (bonds). The objective is to provide investors a comprehensive, diversified investment solution in a single ticker, while actively managing equity-debt weightings in a particular ratio between growth and risk management. This ‘one size fits all’ solution is intended for the investor who wants a hands-off strategy while providing a diversified portfolio without needing to buy and manage individual equity and bond ETFs.

• For example,
  • Conservative Balanced ETF (60% Debt / 40% Equity): This type of ETF would allocate 60% of its assets to bonds (e.g., government and corporate bonds) and 40% to equities (e.g., a broad market index like the Nifty 50). It is suited for risk-averse investors, such as those nearing retirement, who prioritize capital preservation and steady income but want some exposure to growth.
  • Aggressive Balanced ETF (70% Equity / 30% Debt): This ETF takes a more growth-oriented approach by investing 70% in a diversified portfolio of stocks and 30% in bonds. It aims for higher long-term returns than the conservative version but with more volatility. This is suitable for investors with a longer time horizon and a higher risk tolerance.

ETFs vs. Fixed Deposits (FDs)

• Diversification: ETFs provide exposure to a basket of assets, reducing individual stock risk, whereas FDs are a single instrument.
• Risk: ETFs are subject to market volatility, while FDs are low-risk with guaranteed returns.
• Taxation: FD interest is taxed based on income brackets, while ETF gains are taxed as capital gains (short-term gain tax being 15% and long-term capital gain as 10% for equities in India after a period of more than one year).
• Liquidity: ETFs can be traded anytime during market hours, while FDs have lock-in periods with penalties for early withdrawal.
• Returns: ETFs, particularly the equity ETFS, may yield higher returns than FDs, which offer consistent, guaranteed interest (4-7% annually in India). Equity ETFs might provide anywhere from 8-12% or higher on an annualized basis in the long term but entail market risk.

Top Popular ETFs (Potentially Better than FDs)

Nifty 50 ETF (India-specific, e.g., Nippon India ETF Nifty BeES):

A Nifty 50 ETF is an easy and effective method of owning a small portion of the top 50 companies in India, such as Reliance, HDFC Bank, and Infosys, with a single purchase. Consider it an all-in-one package for purchasing shares in all the companies within the Nifty 50 index, which provides insight into the overall health of the Indian stock market. When one unit of an ETF, sometimes referred to as an Exchange Traded Fund, like the well-liked Nippon India ETF Nifty BeES is purchased, one unit means that you bought a small piece of that entire package. This also means that if the value of those 50 companies increases in value, so will the value of your ETF unit and inversely if they fall in value so will your investment value. The ETF is supposed to replicate the performance of the Nifty 50 index itself, giving investors immediate diversification and participation in the expanding Indian economy without the effort and risk of purchasing individual stocks.

Vanguard Total Stock Market ETF (VTI):

When you purchase a single share of VTI, you are not simply acquiring a share of one particular company; instead, you are now an owner of a tiny portion of a huge portfolio that includes every imaginable type of company in the United States, ranging from renowned names like Apple, Microsoft, and Amazon, to thousands of small, obscure names. The purpose of buying VTI is to gain exposure to the performance of a benchmark called the CRSP US Total Market Index, a benchmark that encompasses nearly 100% of the investable U.S. stock market.

iShares MSCI Emerging Markets ETF (EEM):

The iShares MSCI Emerging Markets ETF (EEM) allows your investment in thousands of companies from fast-growing countries, such as China, India, and Brazil. Investing in these respective countries would involve individually selecting stocks, whereas with EEM, you can receive balanced and diversified exposure to emerging markets instantaneously. EEM is an easily-accessible and diversified way to invest in emerging markets, and it replicates the performance of the MSCI Emerging Markets Index. It offers some level of potential greater growth, but with that potential comes a higher degree of risk and volatility in comparison to the more established markets. EEM is commonly recommended for diversifying investments beyond developed markets.

Invesco QQQ Trust (QQQ):

The Invesco QQQ Trust, which trades under the ticker QQQ, is an ETF that allows you to invest in the top 100 non-financial companies listed on the Nasdaq exchange. You can think of QQQ simply as a curated basket of the world’s largest, innovative, technology-centric companies. Buying a share of QQQ is effectively like buying a tiny piece of the best companies like Apple, Microsoft, Amazon, Tesla, and Nvidia and other large companies in the biotechnology or telecommunications space. The goal of the fund is to replicate the performance of the Nasdaq 100 Index, which exactly tracks these innovators. This is what makes QQQ so attractive to investors that want to expressly bet on the growth of the technology sector and other disruptive industries, without the added task of trying to pick which stock will be winners. The QQQ ETF may be more volatile than a fund that tracks the whole stock market due to its heavy concentration in tech. This means that the value may experience much larger swings up or down in value than the entire stock market.

SPDR S&P 500 ETF Trust (SPY):

The SPDR S&P 500 ETF Trust, known as SPY, is an investment that gives you a small ownership interest in 500 of the largest and most important companies in America. You could think of this as a “basket” that contains a small piece of some of the most iconic American companies like Apple, Microsoft, Amazon and Johnson & Johnson, while owning just one investment. When you buy one share of SPY you are purchasing a small fraction of the entire 500 companies that make this index. It is a widely accepted way to give a measure of the overall health of the U.S. stock market. The purpose of SPY is to track this index’s performance. Therefore, SPY is one of the most simplistic, and one of the most popular, investments available to give an investor a tiny, yet diversified, peice of the U.S. economy, with only one security that is easily traded. SPY gets you back much of the diversification you are giving up by the performance of one company, just by the sheer number of companies across various sectors that the investment includes.

Conclusion

To summarize, ETFs provide an adaptable and a potentially greater investment returns option for fixed deposits (FDs), which could provide variability, and access to a diverse range of asset classes (i.e., equities, bonds, commodities). FDs, on the other hand, provide security, with a certain rate of return, but ETFs can provide generally a better return across time (i.e., five to ten year horizon) if an investor is comfortable with a certain level of risk. The commitment to ETFs will have inherent market risk not present in a FD. It is also important to select an ETF aligned to one’s goals, risk needs and expectations, while at the same time getting an opportunity to have a higher return. ETFs are complex financial products, consulting a financial adviser is prudent to review how to position oneself within an ETF for enhanced anticipated returns while maintaining an appropriate level of investment risk.

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