Exchange Traded Funds (ETFs): Definition, Types, Taxation, Benefits (2024)

ETF Meaning

ETF full form is Exchange Traded Funds, and Globally, they are one of the popular investment options for investors. In 2022, globally ETF’s AUM stood at USD 9.6 trillion. Even in India, the popularity of Exchange Traded Funds is going up. Indian fund houses have launched different types of ETFs to cater to the needs of investors in the last few months. As per AMFI data, fund houses have launched 35 ETFs in 2022.

In this blog, we will learn what is exchange-traded fund, how it works, and its advantages and disadvantages.

What is an ETF?

ETF is a type of mutual fund scheme that is listed and traded on the stock exchange and can be bought and sold through the exchange just like stocks. The majority of exchange-traded funds are passively managed while there are actively managed ETFs as well.

Passive ETFs can be structured to track anything like an index such as NIFTY 50, which will invest in the companies of Nifty 50 in the same proportion. They may also track an index representing a sector (like NIFTY Pharma), or a commodity, like gold, which tracks the physical gold price.

To learn more about ETF, check out our video below:

Types of Exchange-Traded Fund

ETFs are categorized based on where they invest. Let’s look at some of the popular ETFs types;

1. Equity or Market ETFs

These Exchange Traded Funds are designed to track a particular index like NIFTY 50 or SENSEX. For example, by investing in Nippon India Nifty 100 ETF, you get exposure to 100 companies comprising the Nifty 100 index through a single investment.

2. Thematic or Sector ETFs

These ETF investments are designed to provide exposure to a particular sector or theme, such as oil, pharmaceuticals, or technology. Rather than tracking the general market, a sector/thematic ETF tracks a basket of stocks that are related to a specific industry or sector, or theme. For example, investing in Axis Healthcare ETF will expose you to different companies in the healthcare sector.

3. Commodity ETFs

These ETF investments are meant to track the price of a commodity like gold, silver, oil, etc. For example, Nippon India GoldBeEs ETF gives you exposure to gold. They help you add commodity market exposure to your portfolio without directly owning the physical commodities.

4. International ETFs

International Exchange Traded Funds are designed to track international markets such as NASDAQ 100 Index or Hong Kong’s Hang Seng Index. Investing in an international ETF can give your portfolio international diversification, which is otherwise difficult. For example, Motilal Oswal NASDAQ 100 Index ETF exposes you to the internet and technology companies listed on the Nasdaq stock exchange.

5. Inverse ETFs

These exchange-traded funds are designed to deliver the opposite performance of the particular index. In this type of fund, you gain when there is a decline in the value of the index, and you lose when the value of the index increases. These are also known as Bear ETFs or Short ETFs.

6. Leveraged ETFs

These funds are similar to other ETFs; however, it uses debts and other derivative instruments such as Future, options, swaps, etc., to maximize the return of funds. It allows you to take a larger position with little capital.

7. Bond ETFs

Bond ETFs are also known as Debt ETFs. These are the types of funds that add a debt component to your portfolio. It provides exposure to fixed-income instruments and generates income from interest payments. These are passively managed investments that track particular indices and invest in securities in the same proportion as the underlying index.

How Does It Work?

Just like any other mutual fund new fund offer (NFO), ETFs are available for purchase from a fund house during the NFO period. However, post the NFO, ETF units are listed on a stock exchange. Further purchase and sale of units happen over the exchange, similar to stock during the market hours.

Exchange Traded Funds also have symbols, just like every company’s share has a specific symbol to identify. For example, the IT company Infosys is listed on the exchange with the symbol INFY, and you can look for the share price of Infosys by searching for ‘INFY’. Similarly, each ETF has a specific ticker symbol as an identifier. Looking for this symbol, you can identify the ETF and find the current price.

How to Invest in ETF?

Investing in Exchange-Traded Funds (ETFs) can be a great way to diversify your portfolio and gain exposure to various asset classes. Here’s a more detailed guide on how to invest in ETFs:

Step 1: Open Brokerage Account

ETFs are traded like normal stocks; you can buy or sell them anytime on the stock market. As you require a demate account for stock trading, you require a demat account for investing in ETFs. So the first step is to open a brokerage account.

You can check various service providers and compare them on the basis of fees, charges, commissions, etc., and select the best which fits your requirements.

Step 2: Select ETF

Selecting the right ETF is an important step in the investment process. ETFs cover a wide range of asset classes, including stocks, bonds, commodities, and more. You should consider your investment goals, risk tolerance, and time horizon before selecting the ETF.

Before selecting the ETF, you should research the ETF by checking its historical performance, holdings, NAV or market price, expense ratio, tracking error, etc.

Step 3: Make Payment

Finally, after selecting the ETF, you must pay for your investment. After you have made the payment, your transaction will be processed in 2-3 days, and your brokerage account will be credited.

Things to Consider While Investing in ETF

There are multiple types of ETFs available in the market, and it may be tempting to identify what best fits your needs. Here are some of the factors you must consider before investing:

1. Past Performance

The first important element to consider is the fund’s past performance. Before investing, you must check its past performance and compare it with the competitors. Past performance does not guarantee future performance, but it is an important element that you should consider.

2. Trading Volume

You should also consider the trading volume of the fund. It shows the number of times ETFs were traded on the exchange, which showcases its popularity among investors. Higher trading volume indicates better liquidity.

3. Expense Ratio

Another important factor you should consider is the fund’s expense ratio. It is the percentage that indicates the amount that you have to pay to the AMC for managing your funds. ETFs are passively managed funds; hence they have a lower expense ratio. But, while selecting between two schemes, you should also consider the expense ratio of funds. Generally, it is advised to select a fund with a low expense ratio.

4. Tracking Error

As ETFs track the performance of the underlying index, there may be a difference between the ETF return and the index return. This difference is known as the tracking error. If the ETF has a lower tracking error, then it means that the fund’s return is closer to the return given by the index. The lower the tracking error, the better it is.

How is ETF Taxed in India?

Income earned through ETFs is liable for taxation. You can earn income by way of dividends and capital gains. Let’s understand their taxability:

1. Tax on Dividends

If you have earned dividend income from your ETF investment, then you will have to pay tax as per your slab rate. Previously, dividends on ETFs were taxed in the hands of the company issuing dividends at 15%, excluding cess. But after 2020-2021, this tax liability was transferred to the hands of investors.

2. Tax on Capital Gains

Capital gains arise when you sell or redeem your ETF investments. Tax treatment of capital gains depends on the type of ETF and holding period. In the case of Equity ETFs, if you redeem it within 12 months, then the resulting gain will be considered as STCG (Short term capital gain), and if redeemed after 12 months, it is considered as LTCG (Long term capital gain)

While in the case of other types of ETFs like Gold ETF, Commodity ETF, etc., the holding period is 3 years or 36 months. If redeemed within 36 months, then the gain will be considered as STCG (Short term capital gain), and if redeemed after 36 months, it is considered as LTCG (Long term capital gain). Here is the tax structure for capital gains:

Terms You Need To Know Before Investing In Exchange-Traded Funds

ETF investors need to be aware of the NAV, market price, and tracking error while investing in ETFs.

1. Net Asset Value(NAV) And Market Price

As Exchange Traded Funds have the features of both mutual funds and stocks, you need to understand the NAV and the market price of the ETF. The value of an ETF’s underlying asset is its net asset value (NAV), and the price at which units are bought and sold on exchange is called the market price of the ETF.

Mostly, there could be a slight difference between the market price and the NAV of the ETF, depending on the demand and supply. As the investor will buy and sell the Exchange Traded Funds through the exchange, the investor’s returns will depend on the market price at the time of buying and selling rather than the NAV.

2. Tracking Error

Tracking error simply refers to the difference in the performance of the Exchange Traded Funds compared to the index it tracks. Tracking error is a function of multiple things like delay in the purchase or sale of securities, expenses of the scheme, and the ETF holdings in cash/cash equivalents. Hence, the ETF cannot mimic the Index’s returns entirely. For practical purposes, the higher the tracking error, the higher will be the difference in the fund’s performance compared to its index. Hence, it makes sense to monitor the tracking error of ETFs and choose the ETFs with a low tracking error.

Advantages of Exchange Traded Fund

Let us now delve deeper into the advantages and disadvantages of exchange-traded funds:

1. Avoids Fund Manager Bias

Most ETFs are passively managed investment options. Hence, unlike active mutual funds, there is no scope for Fund Managers to take any active investment call. The investors are therefore free from any Fund Manager bias.

2. Simplicity

ETF investments are transparent & easy to understand for even new investors. One can easily understand which index the ETF is tracking, and its price in real-time, akin to stocks. Investing in ETFs is simpler than investing in regular mutual funds. One does not have to analyze the fund’s investing style since the ETF purely mimics its index.

3. Lower Turnover Ratio

Portfolio turnover is a measure of how quickly the management of a fund buys or sells securities in the fund over a certain period of time. ETFs generate a much lower turnover in the fund than actively managed mutual funds. This is because Exchange Traded Funds are passively managed and require less buying and selling of securities, which is referred to as having a low turnover. Buying and selling stocks involve costs like securities transaction costs, brokerages, etc. Higher turnover would mean higher costs and thus would impact the returns of the fund.
An actively managed mutual fund will have a relatively high turnover based on the fund manager’s discretion regarding the active management of the portfolio. An ETF will need to change the portfolio only if changes to the underlying index do not happen frequently.

4. Low Expense

Being passively managed, ETFs have very low expense ratios compared to other mutual funds. For example, SBI Nifty ETF has an expense ratio of 0.07%, which is very low if you compare it with a similar actively managed large-cap fund like SBI Bluechip Fund – Direct plan with an expense ratio of 0.97%.

Disadvantages of ETF

1. Liquidity

For non-ETFs, if you need your money back, you can sell the units back to the fund house, and the amount is credited to the bank account. But for an ETF, the units are traded on an exchange, which means there have to be buyers for your units. With some thinly traded Exchange Traded Funds, liquidity could be a concern. Consider a situation where there are no buyers for your ETF. In such a case, you may not be able to sell any of your ETF units or may have to sell your units at a lower price.

2. No initiative to outperform

Exchange Traded Funds track an index and therefore will never outperform the index. Hence, unlike an actively managed fund, the return expectation from an ETF should not be that of outperforming its index.

How Are Exchange Traded Funds Different From Index Funds?

People often get confused between an ETF and an index fund. An index fund is a type of mutual fund with a portfolio constructed to mimic its respective index. Now, this may sound very similar to an ETF! Let us understand the differences.

Although ETFs track indices, there are differences between an Index Fund and an ETF in terms of various criteria. The following table explains these:

Should You Invest In Exchange Traded Funds?

ETFs are low-cost investment options. It also helps you to target and diversify within a particular part of the market or broad market. Once you have identified your investment goals, you can use ETFs to take exposure to any market, asset class, or commodity.

Exchange Traded Funds are also a good investment choice among passive investment options, as they have a lower tracking error than index funds. However, you should look at the ETFs’ liquidity and opt for those with high liquidity to not face any problems while redeeming the investments.

Frequently Asked Questions