Exchange Traded Funds (ETFs), Features, Scope, Example, Challenges

Exchange Traded Funds (ETFs) are marketable securities that track an underlying asset, index, commodity, or basket of assets, trading on stock exchanges like individual stocks. ETFs combine features of mutual funds and equities, offering diversification benefits while providing real-time liquidity. For example, a Nifty 50 ETF mirrors the performance of India’s Nifty 50 index. ETFs have lower expense ratios than actively managed funds, as they passively replicate indices. They can be bought/sold intraday at market prices, unlike mutual funds, which settle at NAV post-market hours. In India, ETFs like Gold ETFs (tracking gold prices) and Banking ETFs (tracking banking stocks) are popular. Regulated by SEBI, ETFs provide transparency, tax efficiency, and flexibility, making them ideal for both retail and institutional investors.

Features of Exchange Traded Funds (ETFs):

• Liquidity

ETFs are traded on stock exchanges like shares, allowing investors to buy or sell them throughout the trading day at market prices. This intraday liquidity makes ETFs highly flexible compared to traditional mutual funds, which can only be bought or redeemed at the day’s closing Net Asset Value (NAV). Liquidity depends on the trading volume and the liquidity of underlying assets. High liquidity reduces the bid-ask spread, lowering trading costs. ETFs with large trading volumes are particularly attractive to active traders and institutional investors. The ability to enter and exit positions quickly makes ETFs suitable for both long-term investment and short-term trading strategies.

• Diversification

ETFs typically track a specific index, sector, commodity, or asset class, allowing investors to gain broad exposure to multiple securities in a single investment. This built-in diversification reduces the impact of poor performance from any single stock or asset. For example, an ETF tracking the Nifty 50 includes exposure to all 50 constituent companies, spreading risk across industries. Diversification is especially valuable for retail investors who may not have the resources to create a balanced portfolio on their own. By holding an ETF, investors can efficiently manage risk and achieve market-level returns without the need for individual stock selection and monitoring.

• Cost Efficiency

ETFs generally have lower expense ratios compared to actively managed mutual funds because they are usually passively managed, tracking a benchmark index. This low cost structure makes them appealing for cost-conscious investors seeking market exposure without paying high management fees. Additionally, ETFs do not carry entry or exit loads, and brokerage commissions are often minimal. Over time, the reduced fees significantly enhance net returns, especially for long-term investors. Since ETFs are traded like shares, investors can control when and how they invest, avoiding unnecessary transaction costs. Cost efficiency is one of the primary reasons ETFs have grown in popularity worldwide.

• Transparency

ETFs offer high transparency because their holdings are disclosed daily, unlike mutual funds which typically reveal portfolios monthly or quarterly. This allows investors to see exactly which securities they own at any given time and understand their exposure to different sectors, geographies, or assets. Transparency also helps investors track whether the ETF is accurately following its benchmark index. For active traders, real-time price and holdings information supports better decision-making. This openness builds investor trust and facilitates portfolio monitoring, making ETFs a preferred choice for those who want full visibility of their investments and greater control over their risk management strategies.

• Flexibility

ETFs combine the diversification benefits of mutual funds with the trading flexibility of stocks. Investors can buy, sell, short-sell, or use margin to trade ETFs, depending on their strategies. This makes ETFs suitable for both long-term wealth creation and short-term tactical plays. They can track various asset classes, including equities, bonds, commodities, and currencies, enabling portfolio customization. Furthermore, ETFs can be used in hedging, sector rotation, or global diversification strategies. The ability to trade intraday and use advanced orders like stop-loss or limit orders gives investors the flexibility to adapt quickly to market conditions while maintaining efficient portfolio management.

Scope of Exchange Traded Funds (ETFs):

• Domestic Equity Market Exposure

ETFs provide investors with easy access to broad domestic equity markets by tracking major indices like the Nifty 50 or Sensex. This allows investors to participate in overall market growth without picking individual stocks. Domestic equity ETFs are suitable for both beginners and seasoned investors seeking core portfolio holdings. They also offer sector-specific ETFs, enabling targeted exposure to industries like banking, IT, or energy. This scope extends to tactical allocation strategies where investors shift focus based on economic cycles. By offering diversified exposure within the home market, domestic equity ETFs reduce risk and simplify participation in national economic growth opportunities.

• International Market Access

International ETFs give investors exposure to global markets without the need to directly trade foreign stocks. These ETFs can track indices from specific countries, regions, or global sectors, such as the S&P 500, FTSE 100, or MSCI Emerging Markets. They help diversify portfolios geographically, reducing dependence on domestic market performance. This scope is valuable for hedging against country-specific risks and tapping into growth opportunities abroad. Currency movements may influence returns, adding both opportunities and risks. International ETFs make global investing cost-effective and accessible, enabling retail investors to benefit from worldwide economic trends while avoiding complexities of direct foreign investment procedures.

• Sector and Thematic Investing

ETFs allow targeted exposure to specific sectors or themes, such as technology, healthcare, renewable energy, or infrastructure. This scope is ideal for investors with strong views on a particular industry’s future growth. Thematic ETFs track trends like ESG (Environmental, Social, and Governance) investing, electric vehicles, or artificial intelligence. They help investors align portfolios with long-term global shifts or niche growth areas. Since these ETFs are diversified within the chosen sector, they balance concentrated exposure with risk management. Sector and thematic ETFs are useful tools for portfolio customization, enabling investors to capture specific market trends without managing individual stock selections.

• Commodities and Alternative Assets

ETFs also provide access to commodities like gold, silver, oil, and agricultural products, along with alternative assets such as real estate investment trusts (REITs). This scope helps investors diversify beyond traditional equity and debt instruments, offering a hedge against inflation and currency risks. For example, Gold ETFs are popular in India for wealth preservation and as a safe-haven asset during market volatility. Commodity ETFs track the price movements of physical assets, making them convenient for retail investors who cannot directly hold or trade these commodities. This flexibility allows investors to balance their portfolios with non-correlated asset classes effectively.

• Fixed Income and Bond Exposure

Bond ETFs give investors access to fixed income securities like government bonds, corporate bonds, and municipal bonds. They combine the steady income potential of bonds with the liquidity and tradability of ETFs. This scope is beneficial for conservative investors seeking stability, predictable returns, and capital preservation. Bond ETFs can be structured to focus on short, medium, or long-term maturities, allowing interest rate risk management. They are also useful for asset allocation strategies, helping balance equity exposure with fixed income stability. By offering a wide range of credit qualities and maturities, bond ETFs cater to varying risk and return preferences.

Example of Exchange Traded Funds (ETFs):

• Nippon India Nifty 50 ETF

This ETF tracks the Nifty 50 index, representing the top 50 large-cap companies listed on the National Stock Exchange of India. It offers investors a diversified exposure to the Indian equity market through a single investment vehicle. The ETF replicates the index by holding the same proportion of stocks as the Nifty 50, making it a low-cost and passive investment option. It is popular among investors seeking to capture the overall performance of India’s largest and most liquid stocks, benefiting from the country’s economic growth with relatively lower risk than investing in individual equities.

• SBI Gold ETF

The SBI Gold ETF provides investors with exposure to physical gold without the need to buy and store the metal directly. The ETF’s units are backed by actual gold holdings, and its price generally tracks the international gold price adjusted for domestic factors. It offers a convenient and liquid way to invest in gold, acting as a hedge against inflation and currency fluctuations. Investors can buy or sell units on the stock exchange during trading hours, enjoying the benefits of gold investment with lower transaction costs and without concerns related to security or purity.

• ICICI Prudential Nifty Next 50 ETF

This ETF tracks the Nifty Next 50 index, which comprises the 50 companies ranked just below the Nifty 50 in market capitalization. It offers investors a way to diversify beyond the largest companies and gain exposure to mid-large cap stocks with growth potential. This ETF is suited for investors seeking higher returns with slightly more risk compared to the Nifty 50. By investing in the Nifty Next 50, investors can capture emerging leaders in the Indian equity market, benefiting from sectors or companies poised for expansion while maintaining broad diversification.

• Motilal Oswal NASDAQ 100 ETF

This ETF provides Indian investors access to the NASDAQ 100 index, which includes the largest non-financial companies listed on the NASDAQ stock exchange in the United States, primarily technology giants like Apple, Microsoft, and Amazon. It allows diversification into international markets, especially the fast-growing tech sector, without the complexities of foreign direct investment. The ETF tracks the performance of the NASDAQ 100, offering exposure to innovation-driven companies. It suits investors looking to benefit from the growth potential of the US tech market, while hedging against domestic market risks.

• Bharat Bond ETF

The Bharat Bond ETF is India’s first corporate bond exchange-traded fund, investing in AAA-rated bonds issued by public sector companies. It provides investors with a low-cost, liquid way to invest in high-quality fixed income securities with a defined maturity date. The ETF offers regular income through interest payments and aims to preserve capital while delivering steady returns. Suitable for conservative investors seeking fixed income exposure, Bharat Bond ETF helps diversify portfolios away from equities and government bonds, offering an efficient alternative for risk-averse investors looking for credit-quality investment options.

Challenges of Exchange Traded Funds (ETFs):

• Liquidity Risks

While ETFs trade on exchanges like stocks, some may suffer from low trading volumes, especially niche or sector-specific funds. This can lead to wide bid-ask spreads, increasing transaction costs. In India, ETFs tracking less popular indices (e.g., thematic or international ETFs) often face liquidity crunches, making it difficult to enter or exit positions without price impact. Investors must check average daily volumes before investing to avoid illiquid holdings.

• Tracking Error

ETFs aim to replicate an index, but imperfect tracking can occur due to fees, rebalancing delays, or regulatory constraints. In India, capital gains tax and securities lending restrictions may widen the gap between ETF performance and its benchmark, reducing returns.

• Market Timing & Volatility

Since ETFs trade intraday, investors may overtrade due to real-time price fluctuations, leading to poor timing decisions. In volatile markets (e.g., during economic crises), ETF prices can deviate sharply from NAV, causing unexpected losses. Algorithmic trading can exacerbate this issue.

• Hidden Costs & Fees

While ETFs have lower expense ratios than mutual funds, additional costs like brokerage fees, STT (Securities Transaction Tax), and GST on management fees add up. In India, Gold ETFs also incur storage charges, eroding returns over time.

• Limited Active Management

Most ETFs are passively managed, meaning they don’t adapt to market changes. During a market downturn, index-tracking ETFs automatically decline, unlike actively managed funds that may hedge risks. Investors seeking downside protection may find ETFs restrictive.

• Regulatory & Tax Complexities

ETFs in India face taxation on capital gains (short-term vs. long-term) and dividend distribution tax (DDT). Changing SEBI regulations on TER (Total Expense Ratio) and disclosure norms can also impact ETF profitability and investor returns.

• Counterparty Risk in Synthetic ETFs

Some ETFs (e.g., inverse or leveraged ETFs) use derivatives and swaps to mimic indices, introducing counterparty risk. If the derivative issuer defaults, the ETF may fail to deliver promised returns. SEBI restricts complex ETFs in India, but global exposure ETFs may still carry this risk.