What are the benefits and limitations of investing in ETFs? MintGenie explains (2024)

Exchange-traded funds (ETFs) can be likened to bundles of marketable securities, providing a wide range of exposure by tracking not just conventional benchmarks such as NSE, BSE, or Nifty 50, but also commodities including gold and silver, themes, and sectors. This adaptability renders them exceptionally versatile instruments for constructing comprehensive investment portfolios.

Similar to individual stocks, ETFs are actively traded throughout the day at market prices, unlike index funds that are bought and sold at their net asset value (NAV) only at the close of the trading day. Although ETFs usually have lower expense ratios compared to traditional mutual funds, their costs are slightly higher than those of index funds due to additional trading expenses. Many investors favour ETFs for potential tax advantages resulting from in-kind creation and redemption processes, which can help minimize capital gains distributions.

Benefits of investing in ETFs

Investing in an ETF offers numerous advantages, making it a favoured option for both beginners and seasoned investors. Here are some of the primary benefits:

Diversification: Instantly gaining exposure to a diversified set of underlying assets is a key benefit of a single ETF. Achieving such diversification through the individual purchase of stocks or bonds can be both challenging and costly. This feature helps mitigate overall portfolio risk by distributing investments across various sectors and industries.

Cost efficiency: Most ETFs generally boast lower expense ratios compared to actively managed mutual funds since they passively track an index instead of maintaining a team of analysts for selecting individual stocks. This results in enhanced long-term returns for investors.

Transparency: The majority of ETFs disclose their holdings daily, providing complete transparency regarding the components of your investment. This empowers you to make well-informed decisions about whether the ETF aligns with your investment objectives and risk tolerance.

Liquidity: These funds are actively traded on stock exchanges throughout the day, similar to individual stocks. This allows for convenient buying and selling of shares at prevailing market prices, offering increased flexibility compared to mutual funds, where buy and sell orders are executed only at the close of the trading day.

Tax efficiency: ETFs typically present tax benefits owing to their in-kind creation and redemption process. This mechanism has the potential to reduce capital gains distributions in comparison to traditional mutual funds, ultimately optimizing your returns.

Accessibility: A diverse array of ETFs spanning various asset classes, sectors, and themes provides the opportunity to customize your portfolio according to specific investment objectives and risk preferences. This adaptability makes ETFs accessible to a broad spectrum of investors, regardless of their experience and knowledge levels.

Minimal investment: Numerous ETFs feature comparatively modest minimum investment requirements, enabling accessibility for investors with smaller capital bases. This flexibility allows you to initiate the gradual construction of your portfolio and engage in market growth, even with limited funds.

Limitations of ETF investments

Similar to any investment, ETFs carry potential downsides. It is crucial to take these into account before making any investment decisions:

Reduced potential for returns: Due to their passive tracking of an index, ETFs may not exhibit significant outperformance of the market over the long term when compared to actively managed funds.

Short-term price fluctuations: The values of ETFs can vary during the day in response to market shifts, potentially resulting in increased short-term volatility compared to more stable investments.

Tracking discrepancy: Certain ETFs may not precisely mirror their underlying index, leading to a slight variance in performance.

In general, the advantages of investing in ETFs frequently surpass the disadvantages for numerous investors. Their diversification, cost-effectiveness, liquidity, and transparency contribute to their value as tools for constructing a comprehensive and efficient portfolio. Nevertheless, investors must conduct thorough research and select ETFs that align with their specific investment objectives and risk tolerance before making any commitments.

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Published: 05 Jan 2024, 02:49 PM IST