Benefits of ETFs (Exchange Traded Funds)

Over the last 3 decades, ETFs have gained popularity both amongst institutional as well as retail investors. The benefits of ETF investing has been realised due to it’s simplicity and lower management fees compared to mutual funds.

The concept of ETFs or Exchange Traded Funds came into being in the Eighties as an alternative to investing in mutual funds. Both individual and institutional investors benefited from holding specific groups of stocks that came with lesser management fees as also higher visibility in intraday prices. On the flip side, the funds’ lower management fees led to the burden being borne by the investor to choose the right investment option. The following are the advantages of Exchange Traded Funds:

They Have A Wider Scope For Diversification

The most significant advantage of an ETF is that it give the investor a wider exposure to groups of equities, styles or market segments . As compared to one single stock, ETFs can keep track of a broader segment of stocks and/ or even mimic country wise returns or returns from numerous countries. For instance, one could study an ETF from BRIC i.e the combination of Brazil, Russia, India and China. The ETF comes with lower fees and assumes the qualities of any equity investment that can be traded easily.

Lower Fees

ETFs are generally passively managed and have to their credit considerably low expense ratios in comparison to other assorted managed funds. It is often see that the expense ratio of a mutual fund is generally higher because of additional costs like management fees, expenses for shareholder accounting at fund levels, overhead expenses such as marketing costs, salaries to fund managers as also load fees pertaining to distribution and sales.

Flexibility of Trading

A significant advantage of ETFs is that it is easily tradable like any other stock even though it provides the holder all benefits of diversifying.  You can purchase ETFs on margin and sell short; their prices are updated as and when they move giving you the opportunity of selling or buying at the opportune moment. This is a significant advantage over mutual funds that are open-ended and the prices of which are available at the day’s end on NAV or net asset value; ETFs allow risk management through futures trading and options, similar to stocks; As they trade like stocks, ETFs allow  you to monitor daily changes of the commodities sector by way of a ticker symbol. Many stock specific websites are equipped with better interfaces as compared to commodity websites to manipulate charts with applications for mobile devices also.

This flexibility of trading makes ETF share trading and portfolio management a snap. You can easily move your money among specific assets like bonds, stocks or even commodities. All it takes is an hour at the most for investors to obtain their allocation into investments they desire with the option of changing their allocation the very next hour. This isn’t exactly applicable to open-ended mutual funds which take several days and the NAV remains unknown till the day’s end. You won’t know exactly the amount receivable when you sell your shares of an open-ended fund or for that matter, how much to invest in another open-ended fund.

The trading flexibility that comes with ETFs gives their investors the added benefit of taking timely decisions on their investments and placing their orders in numerous ways. When you invest in ETFs, you have all the trade combinations characteristic of investing in equity stocks and these include limit and stop-limit orders. You can even purchase ETFs on margin after taking a loan from your broker. You can even  short sell by borrowing securities from your broker and selling these securities simultaneously. This is usually done with a view to buy them back when their prices drop later.

Immediate Reinvestment Of Dividends

Dividends given out by companies belonging to an ETF which is open-ended are immediately reinvested, whereas the timing may vary for indexed mutual funds. However, it needs to be borne in mind that dividends generated by ETFs that are unit investment trust -based are not reinvested automatically. This creates what is known as the dividend drag.

Limited Exposure to Tax on Capital Gains

ETFs are known to be more tax-friendly as compared to mutual funds. This is because the bulk of capital gains tax is payable on the sale and depends solely on the investor. The ETF may buy or sell shares in an attempt to copy the basketful of shares it happens to be tracking. Any capital gains arising from in-kind transfers in ETFs, don’t give rise to tax charges, and this makes it more favorable than mutual funds. The latter need to distribute all capital gains among their shareholders if securities are sold at profits. The distribution of such capital gains is based on the proportion in which the holder makes an investment while also becoming taxable as capital gain. If holders of any other mutual funds sell their units before the record date, the holders remaining invested in the said fund take upon themselves the burden of capital gains, and end up paying taxes even though the fund’s overall value may be reduced.

Lower Discounts or Premium Prices

Trading in ETFs takes place throughout daily trading hours at prices that are more or less close to prices of underlying securities. Thus, if prices are significantly lower or higher than net asset values, arbitrage  brings prices back on track. This differs from close-ended index funds as ETFs trade on demand and supply giving market makers the chance to grab profits based on price discrepancies.