Instead of creating an all-stock portfolio, investors can also create a hybrid one with an exchange traded fund (ETFs) at the core and stocks for support. You get the benefit of both worlds: exposure to a set of stocks (diversifying your portfolio) via ETF and your own picks for any upside kicker. Though this strategy will provide you a muted return than an all-stock portfolio, you will be compensated by the cost and time saved and better downside protection.
What is an ETF?
An ETF is a variant of an index fund. Like an index fund, an ETF also invests its proceeds in stocks that constitute an index in exactly the same weightages as in the index. An ETF is listed on the stock exchange and hence its units have to be purchased via a broker. The expense ratio of an ETF is lower than that of both index funds and actively-managed funds.
ETFs have many more advantages to offer:
Transparency: You don't have to wait till the end of the month to know which stocks constitute the portfolio. You have full knowledge of the portfolio at all times.
Low cost: With an expense ratio of 0.35 to 0.80 per cent, ETFs are the cheapest among collective investment vehicles. The reason for such low cost is that there is no marketing cost, commission or fund manager salary..
Diversification: By taking a position via one ETF, with a single investment you diversify your portfolio. This goes a long way towards reducing the overall risk of your portfolio and you also save on the brokerage cost.
Product variety growing: Gradually the ETF product bouquet in India is becoming more sophisticated. Currently in India the only commodity that you can invest in through an ETF is gold, and the only foreign index that you can take a position in is the Hang Seng Index. Only one debt index based ETFs are available. But as time goes by the variety of ETFs available is bound to increase.
No SIP: Depending on how hands-on an investor you are, this could appear to be either an advantage or a disadvantage. Since ETFs are traded on the exchange you can buy them anytime or as many times during market hours. You have full control over when you wish to buy or sell an ETF. If the markets have gone too high, you may decide not to buy the ETF that month or even book profits in your ETF holdings. On the other hand, when the index has sunk very low, you may decide to invest more than the amount you normally do every month.
Long and short: Other than going long on the market or a sector, you can also go short using ETFs to reflect your bearish views. Though we don't recommend this, an enterprising investor can make money even in a falling market using this instrument. However, remember that this is a very risky strategy.
Types of ETFs
Index ETF: These funds invest their proceeds in the stocks of major indices like Sensex, Nifty, Nifty Junior, etc. These indices serve as a proxy for the market at large. At present seven such ETFs are available. By investing in them you get the benefit of broad diversification.
Sector ETF: A sector ETF invests in stocks of an index that tracks a specific sector.
Commodity ETF: Commodity ETFs are a little different from normal ETFs in that they actually invest in the underlying commodity. At present commodity ETFs in India only invest in one commodity, gold.
Bond ETF: Like commodity ETFs, bond ETFs invest directly in indexes based on bonds and other debt instruments. We have only one bond ETF, Liquid BeES, which invests in short-term debt instruments like call money instruments, treasury bills, etc.
Foreign ETF: Foreign ETFs are very similar to index ETFs, the only difference being that they track a foreign index.
Fundamentally-weighted ETF: Unlike a normal index, where weightage is allocated to different stocks based on their market caps, in a fundamentally-weighted index the weightages are decided based on financial performance - sales, earnings, cash flow, etc.
