Over the past decade, Exchange Traded Funds (ETFs) have steadily grown in visibility within investment circles. Blending the diversification benefits of mutual funds with the flexibility of stock trading, ETFs offer a modern, low-cost route to build exposure across asset classes, geographies, and themes. But what exactly are they, how do they work, and where do they fit in an investorās portfolio?Ā
In this article, lets break down the basics of ETFsācovering their structure, types, potential benefits, and considerationsāso you can better understand this increasingly talked-about investment vehicle.
What is an ETF?
An Exchange Traded Fund (ETF) is a marketable financial product that trades on stock exchanges, similar to individual stocks. As the name suggests, an ETF is an investment fund that holds a diversified portfolio of assets. Unlike a single stock, which represents ownership in one company, an ETF comprises a basket of securitiesāsuch as stocks, bonds, commodities, or other instrumentsāoffering investors an efficient way to achieve diversification.
Exchange Traded Fund (ETF) are funds that track indices such as Sensex, Nifty, etc. When you buy units of an ETF, you actually buy units of a portfolio that tracks the performance of the index. ETFs just reflect the performance of the index they track, making them an efficient way for investors to gain exposure to broader market movements.
How ETFs work?
- Fund construction: The fund is created and managed by an ETF provider or asset management company. This provider selects and pools together a group of securities with the objective of tracking the performance of a specific index (like the Nifty 50 or Sensex), sector, or asset class.
- Unit Issuance: Based on this pool, the provider offers units or shares of the ETF to investors. While investors do not directly own the underlying securities, they hold units of the ETF, which in turn represents a proportionate share in the pooled portfolio. Units of the fund are issued and listed on a stock exchange.
- Buying & Selling: Investors can buy or sell ETF units on the stock exchange throughout the trading day at market-determined prices. This is a key distinction from mutual funds, which are priced only once at the end of the day.
Types of ETFsĀ
| Type of ETF | Underlying Asset | Suitable For | Examples |
|---|---|---|---|
| Equity ETFs | Stock market indices | Long-term market participation, core portfolio holding | ETFs tracking Nifty 50, Sensex, Nifty Next 50, Nifty Bank |
| Gold ETFs | Physical gold prices | Inflation hedge, alternative to physical gold | ETFs tracking domestic gold prices |
| Debt/Bond ETFs | Government or corporate bonds | Low-risk investors seeking predictable returns | ETFs investing in PSU bonds or G-Secs |
| International ETFs | Foreign equity indices or stocks | Global diversification and currency exposure | ETFs tracking Nasdaq 100, S&P 500, global markets |
| Smart Beta ETFs | Factor-based indices (e.g., low volatility, momentum, value) | Passive investors seeking enhanced risk-return profile | ETFs based on smart beta or factor strategies |
| Sectoral/Thematic ETFs | Specific industries or themes | Tactical allocation to high-conviction sectors | ETFs focused on IT, Pharma, FMCG, Infrastructure |
Advantages of investing in an ETF
- Diversification Through a Single Investment: One ETF unit provides exposure to a basket of securities, reducing concentration risk without the need to buy multiple individual stocks or bonds.
- Low Expense Ratio: ETFs are passively managed, so the fund management fees are significantly lower compared to actively managed mutual funds.
- Real-Time Liquidity and Transparency: ETFs are traded on stock exchanges like regular shares, allowing you to buy and sell anytime during market hours. Prices and holdings are publicly available and updated daily.
- Elimination of unsystematic risks: Unsystematic risks refer to the risk of making a wrong investment decision. Since ETFs follow a passive investing strategy, the unsystematic risk gets eliminated automatically; therefore, the overall investment risk is lowered.
Ā
Why one should not consider investing in ETF
- Tracking Error: Tracking error is the difference between an ETF portfolio's returns and the benchmark or index it was meant to mimic or beat. Tracking error is sometimes called active risk. How well an index fund manages its inflows and outflows also determines tracking error. The lower the tracking error, the better the ETF / Index fund. Main reasons for tracking errors are fund expenses, liquidity issues, or imperfect replication.
- Limited Active Management: ETFs follow a passive strategy and do not attempt to outperform the index. They simply mirror itāso in volatile or falling markets, they fall just as much as the index does.
- Non Efficient Investments: Some investors tend to find ETF investing non-efficient, as the returns mirror the returns generated by the underlying indices. Since ETF fund managers cannot use their discretion to choose portfolio securities or deviate from the index weightage, investors cannot expect an outperformance or alpha generation from their ETF investments
Ā
Taxation of ETF: Understanding how ETF are taxed in India is important for making informed investment decisions and optimizing returns.Ā
In India, the tax treatment of an ETF depends on its underlying asset. Equity-oriented ETFs attract equity taxation, whereas debt-oriented ETFs attract debt taxation, while gold, or international ETFs are taxed as per separate rules.
There are two ways in which investors earn money by investing in ETFs ā Dividend income and Capital Gains.
- Taxation on Dividend Income: Some fund houses provide an option to investors to either credit the dividends into their accounts or reinvest in the ETF. These dividends are classified as āincome from other sourcesā and taxed as per the investorās applicable slab rate.
- Taxation on Capital Gains:
| ETF Type | Holding Period | Whether Long-Term or Short-Term Capital Gain | Tax Rate |
|---|---|---|---|
| Equity ETF | > 12 months | Long-Term | 12.5% (on gains exceeding ā¹1.25 lakh) |
| ā¤ 12 months | Short-Term | 20% | |
| Debt ETF | NA | Always Short-Term | As per income tax slab rate |
| Gold ETF, Silver ETF & International ETF | > 12 months | Long-Term | 12.5% |
| < 12 months | Short-Term | As per income tax slab rate |
How ETF is different from Index Fund?
- Both ETFs and Index Funds are passively managed and aim to replicate a specific market index.
- Index Funds are priced once a day, at the end of the trading day, based on the NAV of the underlying securities, like mutual funds. Whereas ETFs are priced in real time and traded throughout the day on stock exchanges, like individual stocks.
- This makes ETFs more liquid and suitable for investors who may want to buy or sell quickly.
- ETFs require a demat and trading account, as they are available only on stock exchanges. While Index Funds can be purchased directly from the mutual fund house and do not require a demat account.
Conclusion
In summary, Exchange Traded Funds (ETFs) offer a flexible, cost-effective, and diversified investment route for both novice and seasoned investors. With structures tailored to various asset classes and investment goals, ETFs strike a balance between mutual funds and direct stock investing. However, understanding their types, associated risks, and tax implications is essential before diving in. Consulting a financial advisor and making thorough due diligence are essential steps to make informed investment decision.
Sources: AMFI, SEBI, Bajaj Finserv, Groww