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What is an Exchange Traded Funds (ETF)?

Exchange traded funds ETF are passive investment options that track the underlying index. In other words, ETF is a portfolio that replicates the composition of an Index in the same proportion. For example, Nifty, Sensex, Bank Nifty, etc. Exchange Traded Funds just track the performance of the index and do not aim to outperform it. Hence these funds are not actively managed by a portfolio manager.

Similar to shares or stocks, ETFs can be bought and sold on the stock exchange. Also, the price of an ETF fluctuates through the day. The net asset value of the underlying securities or stocks determines the market price of the ETFs. The return from an ETF depends on the increase in the corresponding index value.

ETF investment is not actively managed, have lower fees, and more or less offer benchmark returns, making them attractive to many individual investors.

Taxation of exchange traded funds varies based on the type of ETF. Capital gains taxation from Equity ETFs is similar to that of Equity mutual funds. For investments with holding period less than one year, are taxable at Short Term Capital Gains Taxes (STCG) rate of 15% + 4% Cess. While, for investment with, holding period of more than one year, are subject to Long Term Capital Gains Taxes (LTCG) tax of 10% for gains above INR 1,00,000.

On the other hand, Gold ETFs and non-equity exchange traded funds are taxable similar to debt mutual funds. For an investment with holding period less than three years, are subject to Short Term Capital Gains (STCG) tax. The gains are taxable as per the investor’s income tax slab rate. While, for all investments with holding period of more than three years, attract Long Term Capital Gains (LTCG) Tax. The gains are taxable at 10% without indexation benefit, and at 20% with indexation benefit.

Types of ETFs in India

Index Fund ETF

Index fund ETFs are passively managed ETFs with an objective to track a stock market index. For example, Nifty 50, Bank Nifty, BSE Sensex. With investing in an Index ETF, the investor is purchasing a part or share of the portfolio that comprises the securities of the underlying index.

Gold Exchange Traded Fund

Gold ETFs track the performance of the Gold bullion. The prices of gold ETFs are based on the market prices of gold. When the gold prices move up, the value of the gold ETF also rises, and when the gold prices fall, the ETF also loses its value. In India, there are mutual funds that allow investors to invest in ETFs that invest in gold.

Leveraged ETF

Leveraged ETFs invest in debt or derivatives to boost the potential returns of an underlying index. However, these types of ETFs are currently not available in India. These schemes are suitable for short term investments.

Bond ETF

Bond ETFs are similar to bond mutual funds. A bond ETF portfolio comprises bonds that trade on the stock exchange. For example, G-Sec Long term ETF, SBI ETF 10 year Gilt are some of the bond ETFs in India. 

Sector ETF

A sector exchange traded fund ETF invests in stocks of a specific sector. They replicate the benchmark index of that sector. For example, a banking sector ETF invests in bank stocks and replicates and tracks a banking index. They are managed to capture the returns from a particular sector.  The returns hardly sway from the benchmark index.

Currency ETF

Currency ETFs are passively managed ETFs that have their underlying securities as the currency of one or more countries. They aim to provide exposure to forex currencies. Investors use these funds to mitigate their risks in the forex market. Some also use these ETFs for hedging their risk against major economic events.

Inverse ETF

An inverse ETF is made up of various derivatives. Investors of these ETFs benefit from the decline in the value of the underlying benchmark. Investing in inverse ETFs is similar to holding a short position in the market, with an intent to buy it back at a lower price. In other words, investors can benefit when the underlying index value goes down without having to sell short. Inverse ETFs take various future positions by betting on the market to decline. When the market declines by a certain percent, the ETFs benefit by that much percent after deducting the fees. The fees and commission on these ETFs are slightly higher than traditional ETFs.

Equity ETFs

An equity exchange traded fund ETF or simply known as ETF invests in a collection of stocks or equity securities of the underlying benchmark index. These invest purely in equities and hence follow only the equity indexes. In India, the most common equity ETFs track Nifty 50 and Sensex.

Commodity ETFs

Commodity ETFs track the performance of the commodity index that invests in physical commodities or futures contracts. A commodity index tracks either one commodity or a combination of commodities like agricultural products, precious metals, and natural resources. These ETFs are popular as investors can get exposure to commodities without having to learn about investing in commodity derivatives.

How exchange traded funds work?

Exchange Traded Funds (ETFs) are mutual funds that mimic a benchmark index. ETFs mimic the securities as well as the weights of the index. The returns from ETFs are similar to the index returns with hardly any tracking error.

The expenses of ETFs are lower than regular mutual funds as they do not need a portfolio manager to plan the portfolio. There are different types of ETFs as mentioned above, and they invest in shares, commodities and bonds as per their investment objective.

ETFs are mutual funds that trade on the stock exchange. Investors can buy or sell ETFs on the stock exchange using their demat account. The share price of the ETF depends on changes in the market price of the underlying assets.

Advantages of investing in ETFs

Following are the advantages of investing in ETFs:

  • Low Cost: ETFs offer a low average cost, as it will be very expensive for an investor to individually buy and manage all the stocks in an index. Also, ETFs are passively managed investment schemes with lower fund management fees and low expense ratios.
  • Simple: Investing in ETFs is comparatively easier than any actively managed fund. For example, one doesn’t have to analyse the past performance or understand the fund manager’s investment style. It is as simple as selecting the index and investing in the ETF that tracks the index.
  • Liquidity: ETFs can be easily bought and sold on the stock exchange. Therefore, ETFs are highly liquid investment options.
  • Diversification: ETFs offer good diversification. They give access to many stocks across different industries. Or to the best stocks from the same industry, as the case may be.
  • Transparency: ETFs holdings are published every day, hence offering a high level of transparency.

Disadvantages of investing in ETFs

Following are the disadvantages of ETFs

  • Additional charges: ETFs are traded on stock exchanges, and investors need to have a demat account to buy or sell them. Therefore, this comes with additional charges like demat account charges and brokerage fees. Hence increasing the expense ratio. Moreover, operating a demat account requires knowledge of the stock market.
  • Volatility: ETFs are traded on the stock market. Moreover, the underlying assets of ETFs are also traded on the stock market. Hence returns from ETFs are subject to market volatility.

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