What are ETFs?

Imagine if you could invest in a basket of stocks, just like a mutual fund, but trade it like a stock throughout the day. That's exactly what an Exchange-Traded Fund (ETF) allows you to do.

ETFs combine the best features of mutual funds and stocks, offering diversification, flexibility, and low costs. They have gained immense popularity worldwide and are becoming a go-to choice for passive investors in India. But how exactly do they work, and how are they different from mutual funds? Let's find out.

What is an ETF?

An Exchange-Traded Fund (ETF) is an investment fund that holds a basket of securities - such as stocks, bonds, or commodities - and is designed to track a market index. Unlike mutual funds, which can only be bought or sold at the end of the trading day, ETFs trade on stock exchanges just like individual stocks.

This means investors can buy and sell ETFs at any time during market hours at real-time prices, giving them greater flexibility than traditional mutual funds.

ETFs vs. mutual funds - What's the difference?

While ETFs and mutual funds share similarities, they have key differences that set them apart.

Mutual funds are suitable for investors who prefer automatic investments through SIPs and do not want to monitor the market. On the other hand, ETFs are ideal for those who want intraday trading flexibility and lower costs.

How do ETFs work?

Structure and composition

• ETFs hold a diversified portfolio of securities based on an index (e.g., Nifty 50, Sensex, or Nifty Next 50).
  
• Most ETFs are passively managed, meaning they simply replicate the index rather than trying to outperform it.

Buying and selling ETFs

• ETFs trade on the stock exchange, just like individual stocks.
  
• Investors can place market orders (buy at the current price) or limit orders (buy at a specific price).
  
• Unlike mutual funds, which require an asset management company (AMC) to process redemptions, ETFs offer instant liquidity in the stock market.

Role of authorised participants (APs)

• ETFs maintain price accuracy through a mechanism involving authorised participants (APs), which are typically large financial institutions like banks and brokerage firms engaged in trading and market-making activities.
  
• When an ETF's market price deviates from its Net Asset Value (NAV) , APs may create or redeem ETF units as part of their regular operations. This process helps keep the ETF's price closely aligned with its NAV.

Why ETFs are gaining popularity

• Low-cost investing : ETFs typically have lower expense ratios compared to actively managed mutual funds.
  
• Diversification : A single ETF investment gives exposure to multiple stocks or bonds, reducing individual stock risk.
  
• Trading flexibility : Investors can buy/sell ETFs throughout the day, unlike mutual funds, which allow only end-of-day transactions.
  
• Tax efficiency : ETFs tend to be more tax-efficient than mutual funds, as they do not frequently sell securities, avoiding capital gains distributions.

With a growing number of ETFs available in India and globally, investors now have an efficient, flexible, and cost-effective way to participate in the markets.

Conclusion

ETFs bring together the diversification of mutual funds and the trading flexibility of stocks, making them a powerful tool for both beginners and experienced investors. Whether you're looking to track an index, invest in commodities, or gain global exposure, ETFs offer a simple and low-cost way to build wealth.

If you could invest in an entire index with just one trade, wouldn't you consider ETFs?

An investor education and awareness initiative of Nippon India Mutual Fund.

Helpful Information for Mutual Fund Investors: All Mutual Fund investors have to go through a one-time KYC (know your Customer) process. Investors should deal only with registered mutual funds, to be verified on SEBI website under 'Intermediaries/Market Infrastructure Institutions'. For redressal of your complaints, you may please visit www.scores.gov.in For more info on KYC, change in various details and redressal of complaints, visit mf.nipponindiaim.com/InvestorEducation/what-to-know-when-investing

Mutual fund investments are subject to market risks, read all scheme related documents carefully.

Also read:
The history of index investing
Index funds for beginners: A step-by-step guide

This article was originally published on March 10, 2025.