What are the Benefits and Risks of Investing in ETFs?


It’s been two decades since the first ETF (Exchange Traded Fund) was launched in India, in 2002. Since then, its popularity has grown significantly. There are many reasons for this, including the 2008-09 financial crisis, when gold ETFs became extremely popular as safe-haven assets. Over the years, many policies by the Indian Government have also fuelled their rapid adoption, including the 2013 Union Budget when ETFs were deemed eligible asset classes to park pension funds.

A recent study by the National Stock Exchange (NSE) revealed that passive investments by Indian investors have gained steady momentum. Among different options, ETFs have become a preferred choice for many, with total assets under management (AUM) of ETFsrising 40% between March and December 2021, being more than ₹4 lakh crore. The report also indicated an 18% rise in the total number of ETFs during this period.

What makes ETFs so popular for investors? Let’s look at some of their benefits.

Benefits of ETFs

  • Diversification: ETFs are good for investors who want to gain instant diversification in many asset classes such as equities or fixed income, sectors, industry, and even countries. This helps in effective risk management.
  • Trading Flexibility: Investors can buy and sell ETFs during the whole day when markets are open. This makes easy intraday management of a portfolio. Investors can move money between different asset classes if they want.
  • Greater Transparency: Holdings are disclosed daily, so investors can track their fund NAV anytime during market hours.
  • Lower Costs: ETFs are managed passively, which means lower management expense ratios compared to actively managed investments. They also have lower expenses related to monthly statements, transfers, and notifications. This is unlike traditional open-end funds, which have to send statements and reports to shareholders.
  • Shorting or Hedging: ETFs may be short sold against long positions in stocks, as a hedge against a market decline.
  • More Liquidity: They have higher liquidity than mutual funds, making them a valuable tool for raising cash quickly.
  • Tax-Efficient Compared to Mutual Funds: Capital gains tend to be on the lower side compared to actively-managed mutual funds. This means ETF investors pay lower taxes. 

What are the Disadvantages of ETFs?

Like all asset classes, trading ETFs can also come with some risks.

  • Underlying Asset Risk: Investors are exposed to the risks associated with the underlying assets. For instance, a bond ETF is exposed to risks like credit or default risk.
  • Lower Dividend Yields: In dividend-paying ETFs, yields may not be as high as holding a high-yield stock or group of stocks.
  • Liquidity Issues: If an ETF is thinly traded, investors may face liquidity risks. It means they cannot easily exit their investment. Wider bid-ask spreads are signs of an illiquid investment.
  • Pricing Differences: The market price of an ETF does not reflect the exact value of the underlying assets at any point. Prices can diverge from the NAV.
  • Tracking Error: Tracking error is the difference between the return of the benchmark index and the actual return received by an investor.
  • Intraday Pricing Unappealing: Intraday pricing changes are not appealing for long-term investors, who have a time horizon of 10-15 years.

There has been a steady rise in passive investments in India since the pandemic began, as equity markets soared to new heights globally. ETFs can be great ways to build a portfolio and gain exposure to specific industries. Investors who want to capitalise on the market movements without the risk of fund managers associated with actively-managed funds, can look into ETFs.

They have many advantages compared to mutual funds, but also some disadvantages. Investors need to weigh the pros and cons before making a decision.

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