Exchange traded funds, or ETFs, are akin to mutual funds, but with some distinguishing features of their own. ETFs are of three types, viz. index, gold and debt. The gold ETFs invest in gold, while the debt ETFs invest in debt and money market instruments such as bonds, gilts, etc. Among these three, index ETFs are the most popular because these ETFs mimic the performance of the underlying index. Hence, a Nifty ETF would invest in all the 50 shares comprising the Nifty and the amount allocated for each of these shares would be proportional to the weightage given in Nifty to each of the 50 shares. Similarly, a Sensex ETF would invest in the 30 shares comprising the Sensex. The CPSE ETF is also a sectoral index ETF as it invests in the underlying stocks of Nifty CPSE index.
Index ETFs invest in shares comprising the underlying index, which may be general or sectoral index. These ETFs mimic the performance of the specified index by investing in the stock comprising the index, but also allocating the funds in the exact proportion to the latest weightage given to each of the stocks comprising the underlying index. Also, if a company is removed from the index and a new company is brought in its place, the ETF would also exit from the company that is replaced and invest in the stock that has been newly included in the index.
So, when you buy a Nifty or Sensex ETF, you are actually buying a slice of these indices. The performance of the benchmark indices is duly reflected in the index ETFs, so if the index soars, the ETF soars, and if the index tanks, the ETF slumps too.
ETFs are tradeable on the stock exchanges and, therefore, they offer flexibility of share trading along with diversification benefits of an index fund. Also, since ETFs are passively managed funds, the expense ratio is much lower at 0.5-1.0 per cent, as compared to equity mutual funds that can have expense ratio up to 2.5 per cent. ETFs provide investors with exposure to broad segments of the equity, debt and commodities markets, and depending on their risk appetite, financial needs and investment horizon, investors can invest in different kinds of ETFs consisting of various asset classes.