Equity ETF : Meaning and Advantages

Equity ETF

Updated on 13 Oct, 2023

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What is an Equity ETF?

Exchange-Traded Funds (ETFs) that track an index of stocks are known as equity ETFs. These ETFs attempt to closely replicate and track benchmark indexes such as BSE S&P 500, Nifty 50, Nifty IT etc.

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Equity Exchange Traded Funds are investment vehicles that combine the flexibility of investing in stocks with the simplicity of mutual funds. ETFs, like stocks, trade on the stock exchanges and you can buy and sell them anytime during the trading hours.

Equity ETFs are index-based passive investment schemes that invest in securities in the same proportion as the underlying index. The holdings of the ETF are completely transparent due to its index mirroring nature. Equity Exchange Traded Funds also have a lower expense ratio than mutual funds due to their unique structure and portfolio construction mechanism.

There is often a certain difference in tracking the underlying index. In other words, equity ETFs though try to replicate the index perfectly, there is always scope for tracking error. Tracking error is the gap between the ETF’s market price and the fund’s net asset value (NAV).

How Do Equity ETFs Work?

Equity EFTs can be specific to a market capitalization, theme or sector. Thus, you can invest in ETFs that cover large-cap companies, mid-cap companies, small companies, or stocks from a certain sector or theme. Also, Equity ETFs let you target industries that are performing well at the time, such as pharma, IT, energy or banking, making them a popular choice.

Furthermore, Equity ETFs are passively managed funds. In other words, the ETF’s portfolio composition changes only when the asset allocation of the underlying index changes.

For example, the Nifty Bank index comprises top companies in the banking sector. The equity ETF tracking Nifty Bank index will try to replicate the index closely and will have the same banking sector companies in its portfolio.

Thus, Equity Exchange Traded Funds are popular investment options among conservative investors who wish to generate benchmark returns. Furthermore, investing in an equity ETF is a low-cost option, and it offers a diversified investment portfolio.

The price movements of Index ETFs are closely related to the index they follow. To elaborate, the index ETFs portfolio composition closely corresponds to that of the index it follows, and thus the price movements are similar.

Who Should Invest in an Equity ETF?

When choosing an equity ETF for investment, it is necessary to define your investment goals and tenure. On the basis of your goals, risk tolerance levels and investment horizon, you can pick the right fund to invest in. Since equity is a diverse asset class, there are various ETFs available for investors. For example, market cap ETFs, dividend ETFs, international ETFs, sector ETFs, etc.

Thus, you can choose the right ETF scheme depending on your investment goal, risk tolerance levels, and exposure preferences.

Furthermore, equity ETFs are suitable for investors with a long-term investment horizon. Since equity ETFs are passively managed funds, they suit investors who do not wish for active fund management. The expense ratio/ fees are low for these ETFs as they are passive funds.

Thus, investors with not much time to manage their investments and at the same time seeking equity exposure at a low cost can consider investing in equity ETFs.

Things to Consider as an Investor

Following are the things to consider while investing in Equity ETFs:

Investment Horizon

Equity ETF funds are suitable for investors who have a long-term investment horizon. Since equity investments are highly volatile, their returns may fluctuate in the short term. However, the volatility tends to average out in the long run. Thus, it is important to have a long-term investment horizon to enjoy significant returns.

Taxation

Capital gains from equity ETF funds redemptions can be either short-term or long-term, depending on the holding period.

The short-term capital gains are taxable at 15%, while the long-term capital gains are taxable at 10% without the benefit of indexation. However, long-term gains tax is applicable only on gains above INR 1,00,000 in a financial year.

Financial Goals

Equity Exchange Traded Funds track different market caps, themes, sectors and geographies. When selecting an equity ETF, you should have a clear investment strategy in mind. It is very important to choose an ETF scheme that aligns with your goals. For example, if you wish to invest in the banking sector, a suitable ETF would be the one tracking the Nifty Bank Index.

Expense Ratio

Not all Equity Exchange Traded Funds perform the same way, even though they are tracking the same index. Due to tracking error, the equity ETF’s performance may fluctuate. Therefore, before investing in this ETF, you should consider the fees, liquidity of the fund, as well as its tracking error.

Advantages of Equity Exchange Traded Funds

Following are the advantages of investing in Equity ETF funds:

Real-Time Prices: Since equity exchange-traded funds are listed on the stock market, you can buy and sell them just like stocks/ shares at any time during market hours.
Low Cost: Equity ETFs are passively managed schemes. Thus, the number of transactions to design and maintain the portfolio is much lesser in comparison to actively managed funds. As a result, the fund management costs are lower. The ETFs portfolio changes only when there are changes in the index composition. Minimal research costs and portfolio turnover makes these ETFs a low-cost investment option.
Volatility: Equity investments are highly volatile. Stocks are highly sensitive to market fluctuations. However, these ETFs are less volatile than equity mutual funds or stock investments. Since the portfolio comprises of high-quality stocks, the volatility is less.
Diversification: Equity ETFs have a diversified investment portfolio that tracks an index belonging to a market cap, sector, theme or geography. Thus, you can enjoy exposure to all the stocks that form part of an index by investing in an equity ETF.
Passively Managed Funds: Equity exchange-traded funds are passively managed schemes. These ETFs aim to replicate the benchmark index as closely as possible. Thus, it reduces the risk of fund managers’ poor stock selection decisions.

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