Does ETF Investing Work Well As a Buy and Hold Strategy?

Investment in ETFs in India has been growing at a tremendous rate. This is because of the increasing awareness of ETFs as an investment option. ETFs have been famous in the western markets due to their returns being closer to the market. Let’s look at what ETFs are, their advantages and disadvantages, and most importantly, will ETFs work well as a buy and hold strategy.

What are ETFs?

ETFs stands for Exchange-traded funds. The funds invest in different stocks, debt instruments, commodities like gold, etc. These are referred to as the underlying of the ETF. The concept of ETF may seem similar to mutual funds, but they are a bit different.

Like mutual funds, the ETFs are also made of several underlying. But one of the key differences is that ETFs can be bought and sold in the stock market, unlike mutual funds. Thus, investors can buy or sell ETFs throughout the trading hours. Mutual funds are bought and sold at the end of the day.

The ETFs are passive investment instruments. They generally track an index and provide returns similar to that.

Advantages of ETFs

• Easy to trade

As the ETFs are traded in the stock market, they can be easily bought and sold with a click of a button.

• Helps achieve diversification

There are several ETF options in India. For example, Indian investors can invest in NIFTY50 ETF, Bank NIFTY ETF, Gold ETF, Debt ETF, etc. This allows investors to invest in ETFs of different asset classes and achieve diversification.

• Reduces risk

While diversification across asset classes helps reduce asset risk, investing in ETFs can also reduce stock/instrument specific risk. As the ETFs are made up of several underlying, a negative impact on the underlying may not have a significant effect. However, if you had invested in only that single instrument, it would possibly wipe out your investment.

• Lower cost

As ETFs are passive instruments, their expense ratio is generally lower than active mutual funds. Due to the lower costs, the returns also are enhanced.

Disadvantages of ETFs

• Lower liquidity in India

As the ETF market in India is still developing, it is possible to have liquidity issues for ETFs. As a result, investors may be unable to find buyers or sellers for a particular ETF.

• Requirement of a trading account and brokerage charges

As the ETFs are traded in the stock market, it requires investors to have a trading account. This may add to investing costs since most brokers ask for account opening fees and annual maintenance charges. Besides these, the investors also have to pay brokerage fees, STTs and other charges when they buy or sell ETFs. These charges may eat into the returns of the investors.

• No ownership of the underlying

Like mutual funds, most ETFs do not provide you with the underlying stocks or securities ownership. Due to this, investors may be unable to participate in business decisions of underlying companies or get dividends even if the company gives them. The AMC’s may reinvest the dividends.

Is ETF Appropriate to Buy and Hold Strategy?

As mentioned above, ETFs are passive investment instruments. Their returns are closely linked to the market. Therefore, the returns of ETFs may not beat the market like active mutual funds. Before we decide if ETFs are appropriate for buy and hold strategy, let us look at a few returns of ETFs in India.

(Source: Moneycontrol, As of 28th September 2021, https://www.moneycontrol.com/mf/etf/)

The above table shows that ETFs have provided double-digit returns in the past three years. This included the time when investors saw both bearish and bullish markets. The ETFs have provided returns higher than instruments like Fixed Deposits. The returns are also much higher than the inflation rates.

This may make the ETFs an attractive investment for investors looking to buy and hold. Most investors may buy a few stocks which have an attractive future and hold them. However, the risk of withholding stocks for the long term is that you may lose out on your investment in case of a company-specific negative event.

As ETFs are made up of several underlying stocks, the downside risk of a particular stock is less in an ETF.

Think of this as an example. Company X is part of NIFTY50. You invest in Company X as you believe it has a bright future. You also invest in a NIFTY50 ETF. A couple of years later, Company X faces massive issues and is forced to close down. In such an event, the price of the stock of Company X will hit rock bottom. Company X may also be removed from the NIFTY50 index. In such a situation, the fund manager will sell the shares of Company X and buy the shares of the company that comes in the index. Due to this and also since there are several underlying stocks, the ETF will not lose much value.

Conclusion

ETFs can be an excellent tool for buy and hold strategy. The Indian ETF market is still developing. But with increasing awareness among investors, it will only get more popular. Through ETFs, you can buy and hold investments in stocks, gold and debt instruments. This makes it pretty attractive for investors looking to diversify their investments.