Globally, Exchange-Traded Funds or ETFs are popular and the trend is catching up in India too. How does it fit into your portfolio construction?
What is an ETF?
ETF is a basket of securities, that is traded on the exchange just like a stock. They are similar to an index fund in their workings; however since they are also listed on the stock exchanges, you can buy and sell them anytime during the trading hours.
An ETF can be either actively or passively managed. An ETF can be an equity index such as a Nifty 50 and Bank ETF, a commodity index (gold ETF, etc), or a bond index ETF.
Actively managed ones are known as smart-beta funds which tag along with a rule-based system for selecting stocks from an index into the portfolio which in turn might exhibit certain metrics or behaviours.
Investors should consider these factors before investing in ETFs:
For buying ETFs directly from the market, you need to have demat and an equity trading account. Also, each time you trade in ETFs, you pay trading fees. While buying ETFs is cheaper than buying each stock separately, it has its set of challenges. For instance, systematic investing through this route might be costlier than that of lumpsum investing.
Moreover, liquidity is often an issue. ETF investors can find this out from daily volumes and bid-ask difference. A larger difference is indicative of poor liquidity and in a way investors pay a higher price than its underlying in order to own it.
If you are buying ETFs from mutual funds, you get to do so only at the end-of-day NAV. It is also convenient as it does away with the need to open brokerage or Demat accounts while also taking care of liquidity-related issues.
This is relevant for index-based ETFs. Nifty 50 ETF fund need not necessarily mimic the performance of Nifty 50.
There could be differences in returns because of poor liquidity issues (mentioned above) or due to cash held by the fund. Sometimes corporate actions such as dividend distribution (and delay in its deployment) or rejigging of index stocks and their weights can lead to tracking errors.
Lesser the tracking error better is its performance.
Don’t ignore underlying risks
If you are investing in passively managed index ETFs, be aware of the fund’s focus and what types of investment they are going to make.
Don’t be lulled into thinking that all ETFs are safe and have lesser volatility. In the case of international equity ETFs, understand the economic and political nature of the country under consideration.
Similarly, there are funds that curate stocks from the traditional indices based on stock’s fundamentals, quality and price volatility. Ensure they have a good track record of performance before you make any financial commitment.
Check Out ETF vs Index Fund
All ETFs don’t get treated equally from a tax perspective. If equity ETFs are held for more than a year, capital gains from NAV appreciation are treated as a long-term capital gain (LTCG).
While LTCG up to Rs 1 lakh in a financial year is exempt from taxes, anything over and above that threshold is taxed at 10%. Holding for less than a year attracts short-term capital gains taxed at 15%.
For non-equity ETFs, if the holding period is less than 36 months, short-term capital gain taxes are levied at the applicable income slab rates. Selling after 36 months attracts LTCG at 20% rate with indexation benefits.
Understand the fundamental nature of ETFs and their risk-return charactristics to steer away from potential pitfalls. Keep tab of its real cost and tracking error before investing in it.
Learn ETFs vs Mutual Funds