Exchange Traded Funds (ETFs) Explained: Definition, Types and Advantages

3 June, 2025

Synopsis

• ETFs are funds traded on stock exchanges that track indices, sectors, or commodities.

• They may offer diversification, low cost, and intraday trading flexibility.

• Ideal for beginners, but risks like market volatility and tracking errors should be considered.

ETFs have become increasingly popular among both new and seasoned investors. Known for their transparency, flexibility and low cost, ETFs offer a smart way to diversify your investments without the complexity of managing individual stocks or mutual funds. Keep reading on to know more.

What is the Full Form and Meaning of ETF?

The full form of ETF is Exchange Traded Fund. An ETF is a type of investment fund that is traded on stock exchanges, much like individual stocks. An ETF may invest in a basket or class of assets such as stocks, bonds, commodities or currencies.

ETFs combine the diversification benefits of mutual funds with the ease of trading like stocks. You can buy and sell ETFs throughout the trading day, and prices fluctuate in real-time.

How Does an ETF Work?

An ETF pools money from investors and uses that money to invest. For example, a gold ETF holds physical gold or gold-related instruments, while an equity ETF may track indices like the Nifty 50 or S&P 500.

Here's how the mechanism works:

• Investors buy ETF units on the stock exchange.

• The ETF reflects the performance of its underlying assets.

• The fund is managed by an Asset Management Company (AMC). Trading in units of ETF happens between investors on the exchange.

This structure allows investors to build a diversified ETF portfolio with lower costs and higher liquidity than traditional mutual funds.

Types of ETFs

There are several categories of ETFs based on their investment objective:

• Equity ETFs: Track stock indices like Nifty 50, Sensex, or global benchmarks.

• Gold ETFs: Invest in physical gold or gold derivatives to reflect gold prices.

• Bond ETFs: Hold government or corporate debt instruments.

• Thematic or Sector ETFs: Focus on sectors like banking, IT, energy, etc.

• International ETFs: Provide exposure to global markets and foreign indices.

• Actively-Managed ETFs: Managed with a strategy to outperform the index (less common in India).
  
  

Advantages of Investing in an ETF

ETF investment offers several benefits that appeal to a wide range of investors:

• Diversification: With some ETFs, you may gain exposure to multiple securities.

• Low cost: ETFs generally have lower expense ratios than mutual funds.

• Liquidity: Traded on stock exchanges throughout the day, ETFs can be bought or sold instantly.

• Transparency: Most ETFs disclose their holdings daily.
  
  

What Risks Do ETFs Carry?

While ETFs are generally considered safer than individual stock investing, they are not risk-free:

• Market Risk: ETF values can decline if the underlying index or assets fall.

• Tracking Error: The ETF may not perfectly replicate the performance of the index.

• Liquidity Risk: Some niche ETFs may have low trading volumes, leading to wider bid-ask spreads.

• Thematic Concentration: Sector-specific or thematic ETFs may lack diversification.

Always assess your risk tolerance and check the ETF’s underlying portfolio before investing.

How to Invest in ETFs?

Investing in ETFs is straightforward:

1. Open a demat and trading account with a registered broker.

2. Search for the desired ETF on the stock exchange.

3. Place a buy order—just like you would with a stock.

4. Monitor performance and adjust your ETF portfolio as needed.

Unlike mutual funds, there's no need to go through an AMC for purchase. You can buy units of ETFs just like you buy stocks.

ETF vs Mutual Fund: Key Differences

While both serve as tools for diversification, ETFs may offer greater control, especially for active investors.

Start Investing in ETFs with Ease: Open Your HDFC Securities 2-in-1 Demat Account today.

Exchange Traded Funds (ETFs) may offer an investment solution for those seeking diversification, lower costs, and trading flexibility. From gold ETFs to equity ETFs, the choices are many—each designed to serve different risk appetites and investment goals.

As with any investment, it's crucial to understand how ETFs work, evaluate their risks, and choose the right types for your portfolio. Whether you're a beginner or an experienced investor, ETF investment can be a smart step toward financial growth.

FAQs

Are ETFs suitable for beginners?

ETFs can be suitable for beginners due to their low cost, diversification and ease of access. Index ETFs may be good starting points.

Do ETFs pay dividends?

Many ETFs pass on the dividends they receive from underlying securities. These can be paid out or reinvested, depending on the ETF structure.

What is the cost of investing in an ETF?

Apart from the unit price, you pay brokerage and taxes like STT. ETFs also have a small annual expense ratio, usually below 0.5%.

What is ETF liquidity, and why does it matter?

ETF liquidity refers to how easily the ETF can be bought or sold. High liquidity means tighter spreads and better execution for investors.

Are ETFs safe to invest in?

ETFs may be safer when they are tracking broad indices, but thematic or sector-specific ETFs can be riskier. Always align ETF choices with your financial goals.

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*Disclaimer: Terms and conditions apply. This is an information communication from HDFC Bank and should not be considered as a suggestion for investment. Investments in securities market are subject to market risks, read all the related documents carefully before investing.