Category: personal finance

Understanding Exchange-Traded Funds (ETF): Advantages, Limitations, and Popular Uses

What is Exchange-Traded Fund (ETF)?

An Exchange-Traded Fund (ETF) is a type of investment fund that is traded on stock exchanges, much like stocks. ETFs are designed to track the performance of a specific index (such as the S&P 500), sector, commodity (like gold or silver or oil), or a collection of assets like stocks or bonds.

Advantages of ETFs:

  1. Lower Costs: ETFs often have a lower expense ratio compared to actively managed mutual funds.
  2. Liquidity: They can be traded throughout the day on the stock exchange, allowing for quick buy and sell decisions.
  3. Diversification: Although a single ETF may focus on a specific sector, many ETFs offer broad exposure across different industries, asset classes, or regions.
  4. Exposure to Commodities: Investors can get exposure to commodities like gold, silver or oil without needing to physically hold the commodity.
  5. Ease of Trading:
    • Intraday Trading: ETFs combine the best of both stocks and mutual funds by allowing intraday trading, so investors can take advantage of market movements as they happen.
    • Real-Time Pricing: Unlike mutual funds, which are priced at the end of the day, ETF prices fluctuate throughout the day based on supply and demand.

Limitations of ETFs:

  1. Concentration Risk: ETFs that track a specific sector, commodity, or a small number of securities may have concentrated exposure, which can increase risk if that area underperforms.
  2. Trading Costs:
    • Brokerage Fees: While ETFs have lower expense ratios, frequent trading can lead to significant brokerage fees, which can erode returns over time.
    • Bid-Ask Spread: The difference between the buying price (ask) and selling price (bid) can impact the overall cost, especially in less liquid ETFs.
  3. Intraday fluctuations: Due to intraday fluctuations, some trades may be carried out at higher price.

ETFs are popular among both individual and institutional investors due to their flexibility, cost efficiency, and ease of access to diverse markets and assets. But, like all investments, they need careful consideration of their structure, associated costs, and the specific exposure they offer.

Understanding Debt Mutual Funds: Risks and Benefits Explained

A Common Investor Story

Ramesh is a 45-year-old salaried professional. He doesn’t like the ups and downs of the stock market, but fixed deposits no longer give him the returns he wants. His bank relationship manager suggests debt mutual funds, calling them “safe,” “stable,” and “better than FDs.”

Reassured by words like bonds, fixed income, and low risk, Ramesh invests a part of his savings in a debt mutual fund, expecting steady returns and easy liquidity.

But is a debt mutual fund really risk-free?

What Are Debt Mutual Funds?

Debt mutual funds invest your money in instruments such as:

  • Government securities
  • Corporate bonds and debentures
  • Treasury bills and money market instruments

These investments pay interest, which is why debt funds are often seen as safer and more predictable than equity mutual funds.

Why Debt Mutual Funds Feel Safer Than Equity Funds

1. Regular Income from Bonds

Unlike shares, bonds promise interest payments and repayment of principal at maturity. This makes debt funds feel more secure than equity funds, where returns depend entirely on market prices.

2. Lower Day-to-Day Fluctuations

Debt fund NAVs usually move slowly compared to equity funds. This lower volatility attracts investors who want stability or are investing for short- to medium-term goals.

The Risks Most Retail Investors Overlook

Despite their conservative image, debt mutual funds carry risks that often surface only during difficult times.

1. Credit Risk – When the Borrower Doesn’t Pay

Credit risk arises when the company or institution that issued the bond fails to pay interest or return the principal.

Why it matters:
To earn higher returns, some debt funds invest in bonds issued by weaker or lower-rated companies. If such a borrower defaults, the fund’s value can fall sharply—sometimes overnight.

Real-life reminder:
In 2018, IL&FS, a company rated AAA, suddenly defaulted on its debt. Several debt mutual funds had exposure to its bonds and commercial paper. Investors who expected “safe” returns were shocked to see losses and write-downs. The event also triggered panic across NBFC and housing finance stocks, proving that credit risk can appear without warning.

2. Interest Rate Risk – When Rates Move Against You

Bond prices and interest rates move in opposite directions.

What this means for you:

  • If interest rates rise, existing bonds lose value, pulling down the fund’s NAV.
  • If interest rates fall, bond prices rise, benefiting the fund’s NAV.

Debt funds that hold long-term bonds are more sensitive to interest rate changes and can show noticeable ups and downs, even without any default.

3. Liquidity Risk – Getting Your Money When You Need It

Liquidity risk occurs when many investors try to exit the fund at the same time.

What can go wrong:
During market stress, a fund may struggle to sell its bonds quickly. This can force the fund to sell at poor prices or, in extreme cases, restrict withdrawals—something many retail investors assume can never happen.

What This Means for Investors Like Ramesh

Debt mutual funds are not the same as fixed deposits. They:

  • Do not guarantee returns
  • Can fall in value
  • Are exposed to market events and credit quality

They can be useful tools—but only when chosen carefully and matched to the right goal and time horizon.

A Practical Investment Tip for Retail Investors

Before investing in any debt mutual fund, look at the monthly fact sheet. Focus on:

  • How much of the portfolio is in AAA-rated bonds
  • Exposure to lower-rated or unrated instruments
  • Average maturity and duration compared to the benchmark

If the fund is taking extra credit risk to show higher returns, make sure you are comfortable with that risk.