What is an ETF (Exchange Traded Fund)?
ETFs were launched in India in December 2001, though the fund flow in the ETF industry was very scanty till August 2015. Research shows that the effective growth in Nifty50 AUM and in the industry has taken place only in the last five years.
An Exchange Traded Fund (ETF) is basically a fund that pools in funds from several investors and can be traded on the stock exchange or the secondary capital market, similar to shares.
You need to have a Demat account and a Trading account to start investing in ETFs if done via an investment firm. It is a passively managed fund with a designated fund manager and has a Net Asset Value (NAV) like a mutual fund.
Though they are traded like stocks, their individual price is not determined by the Net Asset Value (NAV), instead by the demand and supply mechanism operating in the market.
Since ETFs track benchmark indices, their returns are closely linked to market movements, to overcome most mutual fund investment schemes. The buying and selling of the ETF units are usually done by any registered broker at any of the recognised and listed stock exchanges in India.
Since the units of the ETF are listed on the stock exchange and the Net Asset Value (NAV) varies according to the market sentiments, they are not traded like any other normal open ended equity fund.
The investor has the liberty to trade in as many units as feasible on the exchange, without any kind of restrictions being imposed on them.
To state it very simply, ETFs are investment funds that track indices like the CNX Nifty or BSE Sensex, etc. Hence, when you decide to invest in the shares of an ETF, you are investing in the shares of a portfolio that tracks the yield and return of its native index.
Investing in ETFs does not entail it to outperform their corresponding index, rather replicate the performance of the Index as they depict the true picture of the market.
Are Exchange Traded Funds (ETFs) a Lucrative Option for Investment?
Exchange traded funds (ETFs) are a safe bet for beginner investors due to their innumerable benefits like higher daily liquidity and lower fund fees as compared to the mutual funds. Here’s a FREE course on mutual funds
Few factors like the wide range of investment choices, low expense ratios, high liquidity, option of diversification, low investment threshold etc. make them an attractive investment option for the individual investors.
These special attributes render the ETFs to be perfect options for adopting various trading and investment strategies to be used by new traders and investors. ETFs are a lucrative investment option due to the following reasons:
- Diversification of the portfolio –
In today’s volatile market, diversification of the financial portfolio is mandatory and hence the need for ETFs, which can introduce investors to a huge variety of market segments.
Learn more about how to plan your finances
You can diversify your mutual fund portfolio by investing in Gold ETFs, by using the price of physical gold as its benchmark. You can also diversify your wealth among ETFs covering different types of investments like commodities or bonds.
- High Liquidity due to absence of a lock-in period
Investment in Exchange Traded Funds help in portfolio diversification along with providing liquidity. They are open ended funds with no lock-in period, which gives them the liberty to withdraw their holdings according to their requirement.
Since there is no holding period, investing in ETF is a lucrative investment option.
- Cost Efficiency due to Passive Management–
The expense ratio for maintaining the ETFs are comparatively lower as they are not actively managed like majority of the mutual funds.
Since there are no management fees or commissions involved, the incremental value of the overall fund is usually increased.
An ETF held with a low expense ratio can add on to the pay-outs if held for very long. For example, index ETFs just track the index, so the portfolio manager does not need to manage the fund. This calls for a lower management expense ratio (MER).
- Single and transparent transactions –
Investing in ETFs require you to make one single transaction similar to owning a mini portfolio.
Therefore, when you have to track the performance of this portfolio, for example if you have invested in a Gold ETF, you would need to track the price movements of gold only as a daily commodity, which is much easier for the investor.
Also most of the ETFs publish their holdings on a daily basis, hence you can find out their holdings, their relative weightage in the funds and if there has been any movement, thereby fostering transparency in the financial chain..
- Offer flexibility to buy and sell –
Unlike mutual funds, ETFs can be purchased and sold from an investment firm or at the stock exchanges on a daily basis, similar to the intraday trading mechanism.
They have the flexibility to be bought short and sold at a profit margin in a day during the market operating hours, at the current market price at the time of the transaction.
- Professional Fund Management –
Though ETFs maintenance or operation costs are pretty low, they are very professionally managed.
- Tax Efficiency –
ETFs are considered to be equity oriented schemes, which entails them to follow a taxation norm similar to any other equity related investment scheme.
Types of Exchange Traded Funds
With several options among ETFs available in the financial markets these days, consumers tend to get perplexed in which to invest.
Hence there are 4 broad categories of ETFs that one can invest in, namely:
- Equity ETFs – Equity ETFs usually track the movement of sector or industry specific stocks. Here the performance of the index or the specific sector is replicated by investing in stocks accordingly.
- International exposure ETFs – There are few ETFs that track stock indices of foreign stock markets. Since they give the investors an opportunity to gain exposure in some international markets, they are actively involved in weaving the growth stories for few economies.
- Debt ETFs – Few exchange-traded funds try trading in fixed-income securities.
- Gold ETFs – Gold investment is always considered a great hedge against currency fluctuation and a volatile market. However, investments in physical gold is faced with several concerns like quality, security, resale, taxation, etc. Hence, Gold ETFs are a safe option where you can invest in gold bullion, thereby having gold in your portfolio without the risk or fear of investing in physical gold.
Factors to be kept in mind before you decide to invest in an ETF
Today’s financial market is flooded by too many options even within the ETFs. There are four factors that one must consider before you decide to invest in an ETF:
- Trading Volume of the ETF – You should chose an ETF with higher trading volume if you need liquidity and a good price for the units traded on the stock exchange.
- Class of the ETF – Since ETFs are of four types, equity, international, gold and debt, once a category is finally selected, its sub category also needs to be decided. The specific sector ETF or their market capitalization needs to be focused upon if you are investing in an equity ETF.
- Lower Expense Ratio – Usually the expense ratio of an ETF is much lower than an actively managed fund. But even then many fund houses offer more discounts on the expense ratios to attract more investors, thereby increasing the chances of higher returns.
- Lower Tracking Order – ETFs usually track an index as they invest in securities that comprise the index in a manner that the returns are almost similar to those offered by the index, thereby making some differences feasible between the returns offered by the index and the ETF. Tracking error usually identifies variance in the performance of the ETF in comparison to the underlying index. If the tracking error is lower, the returns of the ETF will be closer to that of the index. Therefore, you should always invest in ETFs with a lower tracking error.
Comparison between Mutual Funds, Stocks and ETFs
A detailed study on ETFs has been quite helpful in understanding the market and drawing a comparison between them as against the mutual funds and stocks:
|Mutual Funds||Stocks||Exchange Traded Funds|
|Definition||A financial set up comprising of a pool of money collected from many investors to invest in different securities like bonds, stocks, money market vehicles and various other assets.||The investment capital raised by a company through the issue of shares, thereby signifying some ownership in that company for the investors.||An exchange traded fund (ETF) is an asset class consisting of a collection of securities like stocks, that track an underlying index or a specific sector.|
|Risks Involved||Though the exposure is diversified, there are market specific risks.||Very risky proposition as the performance of the stocks are directly proportional to the company’s performance.||Though the asset class is diversified, it however carries market related risks.|
|Trading Time||Mutual fund trading is done only once a day after the financial market is closed.||Can be traded throughout the day.||Can be traded throughout the day.|
|Degree of Control||Not very highly regulated or controlled investment.||Very highly controlled investment.||Higher control on these type of investments as compared to mutual funds but lesser than stocks.|
Tax Implications on ETFs
The taxation policy applicable on ETFs are quite unique as compared to the tax treatment meted out to mutual funds.
Read more about taxation in mutual funds
The index ETFs and sectoral ETFs are considered as equity-oriented schemes from the tax perspective. They have the unique selling proposition of creating and redeeming shares with in-kind transactions, which are not rendered as sales.
Since there is no sale involved, they are not taxable.
However, if you plan to sell your ETF investment, this transaction will be taxable. The tenure of holding onto this ETF investment will decide if it was a short-term or long-term profit or loss.
Therefore, research reveals that short term capital gains from ETF units held for less than one year are taxed at 15% vis-a-vis the long term capital gains on ETF units being held for more than one year, being taxed at 10% without any indexation benefit.
If you are a new investor planning to enter the Indian financial market, ETFs consisting of a basket of securities offer a well-diversified approach. They are a much better proposition than purchasing the stocks directly for first time investors.
You should do a thorough research on the investment options available and devise a suitable investment plan based on your financial objectives, tenure to invest, intricacies of investing in ETFs and your risk tolerance level.
Since these funds are passively managed, they are cost efficient and usually match the returns offered by the index.
Also if you are an aggressive investor, ETFs are still a good option for stable investments if utmost planning is done well in advance.
Thus, with adequate knowledge and research, all the first time investors should allocate some of their funds to ETFs for a better wealth creation.