The Role of ETFs in a Balanced Portfolio

Creating a balanced investment portfolio is one of the most important steps to achieving financial stability and long-term growth. While traditional tools like stocks, bonds, and mutual funds have long been popular among Indian investors, Exchange-Traded Funds (ETFs) have emerged as an affordable and convenient investment avenue. When used alongside other investments, ETFs can be a strategic way to balance and diversify your portfolio to reduce costs, mitigate risk and optimise return potential.

Let’s explore how ETFs can contribute to a balanced portfolio and their increasing popularity among investors.

What are ETFs and how do they work?

ETFs, or Exchange Traded Funds, are a type of investment fund that pools money from multiple investors to buy a basket of securities like stocks, bonds, or commodities. Unlike mutual funds, ETFs trade on the stock exchange just like individual shares. This means you can buy and sell them during market hours at prevailing prices.

Each ETF typically tracks an underlying index, such as Nifty 50, Sensex, or specific sectors like IT or healthcare. As the value of the underlying assets changes, the ETF’s value fluctuates proportionally, making it easy to understand and track.

How ETFs can help build a balanced portfolio

Building a balanced portfolio involves diversifying investments across different asset classes, geographies, and risk profiles. ETFs make this process easier, thanks to their unique features. These include:

1. Diversification at low cost: ETFs provide instant diversification because they invest in a broad range of securities within an index. For instance, investing in an ETF tracking the Nifty 50 gives you exposure to the top 50 companies in India without having to buy each stock individually. Moreover, ETFs generally have lower expense ratios compared to mutual funds, allowing you to save on fees over the long term.

2. Flexibility and liquidity: Since ETFs are traded on stock exchanges, they typically offer high liquidity. You can easily buy or sell them during market hours, unlike mutual funds, which require end-of-day NAV calculations. This flexibility makes ETFs suitable for both short-term and long-term investment strategies.

3. Transparency: ETFs are highly transparent, as their holdings are disclosed daily. This gives you a clear view of what you are investing in and how your portfolio is performing.

4. Accessibility to niche markets: ETFs allow you to invest in specific sectors, themes, or geographies that might be challenging to access otherwise. For instance, you could invest in a gold ETF to gain exposure to gold prices or a global ETF to diversify internationally. These options make it easier to align your portfolio with your financial goals. This advantage is offered by several index mutual funds too and investors can choose whichever of the two avenues they find more suitable.

Building a portfolio with ETFs

When constructing portfolio, it is important to allocate your investments across asset classes based on your risk tolerance and financial objectives. ETFs can form a part of a well-rounded portfolio that also includes active mutual funds for the potential to earn better returns than the market in the long term as well as stable avenues such as PPFs and fixed deposits, among others. Here are the different types of ETFs that you can consider for your portfolio:

1. Equity ETFs for growth potential: Equity ETFs provide exposure to stock markets, which have the potential for high growth over time. For Indian investors, options like Nifty 50 ETFs or Sensex ETFs offer a low-cost way to participate in the country’s top-performing companies. If you’re looking for more specific growth opportunities, sector-based ETFs like IT or pharma can add targeted exposure to your portfolio.

2. Debt ETFs for relative stability: Debt ETFs invest in fixed-income securities like government bonds or corporate debt, providing relative stability and the potential for regular income. They can be a suitable choice for conservative investors or those looking to reduce overall portfolio volatility

3. Commodity ETFs for hedging: Commodity ETFs, such as gold ETFs, can serve as a hedge against inflation and economic uncertainty. Gold is a traditional favourite for Indian households, and gold ETFs offer an easy way to add this asset class to your portfolio without worrying about storage or purity.

4. International ETFs for diversification: Global diversification is becoming increasingly important, especially for Indian investors looking to mitigate country-specific risks. International ETFs allow you to invest in overseas markets like the US, Europe, or emerging markets. For instance, an ETF tracking the Nasdaq 100 can give you exposure to leading global tech giants.

Through such a balanced portfolio, you can potentially work more effectively towards your goals, such as retirement. Once you reach retirement, a Systematic Withdrawal Plan (SWP) in mutual funds can help you potentially generate a steady stream of income from your corpus built through mutual funds, ETFs or any other investment avenue. An SWP allows you to withdraw a fixed amount from your investments at regular intervals. The amount that remains invested after each withdrawal continues to get market exposure and potentially grow. This can help your corpus last longer than it would through a lumpsum withdrawal. An SWP calculator can help you plan your withdrawal strategy.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.