Exchange Traded Funds (ETF)

What is an ETF?

Exchange traded funds are passive investment instruments that replicate the underlying index. In other words, ETF is a portfolio that matches the composition of an Index in the same proportion. ETFs merely track the performance of the index and hence are not actively managed by a portfolio manager. They do not attempt to outperform their respective index. 

These can be bought and sold on a stock exchange. The price of ETFs fluctuates through the day. Its value is determined based on the net asset value of the underlying asset or stocks in it. Though ETFs are highly liquid and bought for a lower fee, making them attractive for individual investors.

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.

What are NSE Exchange Traded Funds?

Lately, ETFs have been gaining importance over other investment options. Investors who find it challenging to analyze and pick a stock to have in their portfolio have been investing in ETFs. 

ETFs replicate the indices on NSE. They aim to earn returns that are close to the gains of the securities in the index. The different types of ETFs are Equity, Gold, World Indices, and Debt. 

Equity Exchange Traded Funds integrate the benefits of stock investments and equity mutual funds into one investment product. Also, holdings of the ETFs are entirely transparent, as they mimic the index.

What are Gold Exchange Traded Funds?

Gold Exchange Traded Funds integrate the flexibility of stock investment and the simplicity of gold investments. Gold funds are available in the cash market of NSE. These gold ETFs, too, are passive investments that invest in Gold Bullion. These are also not actively managed funds. Based on the prevailing rate of the underlying asset i.e. gold, the gold funds price is determined.

Global Equity Exchange Traded Funds allow domestic investors to invest in international indices.

Debt Exchange Traded Funds allows an investor to take exposure to fixed-income securities. Debt ETFs combine the benefits of investing in debt instruments, along with stock investment and mutual funds.

Costs involved

Though the expense ratio for ETFs is lower, there are other costs involved. Since ETFs are bought and sold on the exchange, each transaction requires the investor to pay brokerage to the broker.

Also, there are securities transaction tax, the difference between the ask-bid spread, and all the other expenses while trading in stocks. An investor needs to be aware of the portfolio manager, his chargers, expense ratio, STT and brokerage in order to take a well informed decision

How to invest in ETFs?

Investing in ETFs is similar to that of stock investing. ETFs trade on the stock exchange, just like any stock. Therefore, having a Demat account will serve the purpose. Similar to stocks, these ETFs are bought on margin, sold short, or held for long-term. 

ETFs offer diversification when compared to single stock investing. It gives the investor greater flexibility to invest across markets, sectors, regions, or asset types. ETFs are traded in high volumes as they are a collection of stocks. These high volumes indicate high liquidity. Therefore, it makes it quite easy to enter and exit the positions.

Liquidity

Retail investors buy and sell ETFs in the secondary market. But, the liquidity aspect of ETFs is beyond this. Primary liquidity is the other type of liquidity. Here funds are created or redeemed in predefined lot sizes in exchange for a predefined underlying portfolio basket.

Allotment to the investors is after the underlying portfolio basket is deposited with the fund along with the cash component.   

The determinants of liquidity of both markets are different. In the secondary market, liquidity is the function of the value of ETFs shares traded. While in the primary market, liquidity is the function of the value of the underlying securities or shares.

Benefits of Investing in ETFs

The unique structure of ETFs has made them suitable for all types of investors. For investors with any investment horizon – long or short term. For long term investors, ETFs give an excellent diversification to their portfolio without much cost. On the other hand, for short term investors, they provide liquidity as they can trade intra-day. Since the initial investment for ETFs is low, it attracts retail investors. 

The benefits of investing in ETFs apart from that they come with a low cost for an investor are: 

• ETFs trade on the stock exchange. Investors can buy and sell at any time at the prevailing price, which is close to the NAV of the scheme. 
• ETFs are funds that closely track the performance of the index throughout the day. With ETF tracking any trading opportunity arising during the day can be quickly seized. Hence, ETF tracking is very crucial to seize an opportunity.
• New units of the ETF can be created or outstanding units redeemed directly with the fund.
• Tracking error is low for ETFs as compared to a typical index fund. This is due to lower expenses and the creation/redemption process of new units. The tracking error is a gap between the NAV of the ETF and the underlying index
• ETFs are used by traders and institutional investors for hedging risk, as they can be borrowed and sold short.

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ETF Taxation In India

ETFs attract Security Transaction Tax, and the gains from investments are taxed as follows:

For an investment horizon of less than one year, ETF investments attract Short Term Capital Gains Taxes (STGC) of 15% + 4% CESS. 

While for investments above one year, the returns fall under Long Term Capital Gains Taxes (LTCG). Accordingly, attract 10% tax for gains above INR 1,00,000. 

The taxation varies for Gold ETFs and ETFs other than equity. The investment horizon is three years for long term capital gains. The tax rate is at 10% without indexation and 20% with indexation, whichever is beneficial for the investor.

For an investment horizon of fewer than three years, Gold ETFs attract Short Term Capital Gains. The gains are added to the total income of the investor and taxed according to the tax slab.

Things to consider before investing in ETFs

Investment Strategy:

ETFs are across Equity, Gold, World Indices, and Debt, the investor should have a clear investment strategy while choosing the right ETF. Analyzing whether the portfolio should have a broad market index, specific sector, region, or a thematic one is very important. 

Investment Horizon:

Knowing the investment horizon is a significant factor. Be it for a short or long term, ETFs are beneficial for investors. While investing, the duration has an impact on taxation. Staying invested for longer will help in lowering your tax liability. Hence consider the horizon before deciding whether to invest in an ETF or not.

Risks:

Like any other investment instrument, ETFs too, are subject to market risks. In order to invest in an ETF, understanding risk is essential. Adverse developments in the market or sector in which ETFs have invested are the most significant risks. 

Costs:

Though ETFs are said to have a lower expense ratio, it is better to look into all the costs associated with ETF investments. The given expense ratio is a total of custody, administration, auditing, and management fees. At the same time, there are other additional costs involved, such as ask-bid spread, brokerage fees, and rebalancing costs.

Income Tax Implications on Exchange Traded Funds

ETFs invested for less than one year attract 15% STCG tax. While for investments above one year, the LTCG tax is at 10% for gains above INR 1,00,000. 

For Gold ETFs and ETFs other than equity, investments beyond three years are considered for LTCG taxation. The tax rate at 10% with indexation and 20% without indexation. For investments less than three years, the gains are taxed at investors’ income tax slab rates.

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