ETFs explained: A smart, low-cost way to grow your wealth

Index funds are usually touted as the 'no effort' way to create wealth in the market, as they not only replicate a broad market but are also low-cost. What if we say there is an option that is not only a lot more accessible but also has a lower cost?

You can try out ETFs (Exchange-Traded Funds) - more specifically, index ETFs. And if you wish to invest in global stocks , you can check out the tax-friendly option of international ETFs.

In this article, we'll discuss these two options. These can be a quicker alternative to researching individual stocks.

The basics of ETFs

ETFs, or Exchange-Traded Funds , are highly similar to funds, except ETFs are traded in exchanges. Similar to funds, ETFs also collect money from investors and invest in a wide range of companies. They have their own AUM, NAV and fund manager, too.

However, ETFs are more similar to the less common closed-ended funds. Although you can buy an ETF from the exchange, you are simply getting a share in the investment pool, rather than your money going directly into the investment pool. The mechanism is similar to investing in a company's stock, where new shares are not created whenever you buy, but rather existing shares are traded between participants.

These schemes trade on stock exchanges throughout the trading day, meaning their prices fluctuate based on supply and demand - similar to individual stocks. While each ETF has a Net Asset Value (NAV) , much like a mutual fund, its market price is governed by demand and supply dynamics. As a result, an ETF could trade at a premium or discount to its NAV.

Now, let us look at the two options for investing in equities.

Investing in index ETFs

Index ETFs track broad market indices such as Nifty 50, Sensex, etc. They aim to replicate the performance of the underlying index, offering investors a cost-effective way to gain market exposure. Because they are passively managed, index ETFs have lower expense ratios compared to actively managed funds.

The best part is, that most of the ETFs available on the market are indistinct from each other. This means not much research or analysis is required to select a particular ETF for your investment goals.

Suggested read: What is a Nifty ETF?

Investing in international ETFs

Similar to how there are ETFs tracking Indian indices, firms have also created ETFs to track international market indices. These ETFs provide access to global markets, tracking indices like the FTSE 100, S&P 500, or Nasdaq 100. International ETFs help diversify geographic risk and tap into growth opportunities outside India.

For many months, India-based US ETFs, i.e., domestic ETFs tracking American market indices, were trading at a premium. This is because the RBI (Reserve Bank of India) has a $7 billion overall limit for fund houses investing in foreign securities. In early 2022, this cap had been reached, prompting SEBI to close all fresh investments into such schemes.

As a result, fund houses couldn't create new ETF units. Hence, limited supply and increasing demand led to heightened premiums for such ETFs. Other factors drove this premium upwards as well; we've discussed them in detail .

Furthermore, these schemes are an easier way to invest in global markets. This is because reporting foreign assets as well as gains from them is highly complicated . International ETFs help you avoid all the hassle as they receive equity-like tax treatment .

ETFs vs Stocks: What are the key differences?

This new investment option may confuse you at first. So, here's a glance at how it is different from stocks:

ETFs vs Mutual funds: How do they differ?

These schemes sound a lot like mutual funds, right?

But here's how they are quite different from one another:

Suggested read: ETFs or index funds: Where should beginners invest?

What are the advantages of investing in ETFs?

Investing in ETFs offers several benefits that make them an attractive option:

• Low cost: ETFs usually have lower expense ratios than actively managed mutual funds because they track indices passively.
  
• Liquidity: ETFs trade on stock exchanges throughout the day, allowing investors to buy or sell anytime during market hours.
  
• Diversification: By owning a basket of securities, ETFs reduce the risk associated with investing in a single security.
  
• Flexibility: ETFs offer the ability to trade like stocks, use limit orders, and short sell.

What risks and challenges should you consider with ETFs?

While ETFs offer many advantages, investors should be aware of certain risks:

• Market risk: ETFs follow the market or sector trends, so they can lose value in downturns.
  
• Tracking error: Sometimes ETFs don't perfectly match the performance of their benchmark index. This can be due to either the fees or the fund manager having certain limitations in matching the index's composition.
  
• Liquidity concerns: Some ETFs, especially niche or low-volume ones, may become difficult to buy or sell promptly.
  
• Dividend distribution: If you can take on some risk, a stock with a high dividend yield would generally outmatch an ETF. After all, an ETF will average out the dividend yields of the underlying companies of the index - this leads to lower dividends.

How to invest in ETFs?

It is easy to get started. Here are the steps:

• Open a Demat and trading account : ETFs trade like stocks, so you need an account with a brokerage.
  
• Choose the right ETF : Consider your risk appetite, investment horizon, and financial goals. Look at expense ratios, tracking error, and liquidity.
  
• Buy ETFs through a stockbroker : Platforms like Zerodha, Upstox, ICICI Direct, and HDFC Securities offer easy ETF trading.
  
• Monitor and adjust : Regularly review your portfolio and rebalance if needed to stay aligned with your objectives.

Who should invest in ETFs?

ETFs are suitable for:

• Beginners seeking diversified market exposure without complex stock picking.
  
• Passive investors who want low-cost, long-term investment options.
  
• Investors looking to diversify across asset classes like equities, bonds, and commodities.
  
• Those who value liquidity and the flexibility to trade anytime.

Conclusion

Searching for the right ETF is quite simple. Just check for a low expense ratio, a low tracking error, and a high-volume ETF - that's it, and you're good to go.

However, if you are keen on making strides in your portfolio, the importance of individual stocks cannot be overstated. If you find that the research is tough and you don't want to make costly mistakes, you can try out Value Research Stock Advisor .

Also read: A passive, very passive fund

This article was originally published on May 15, 2025.