Exchange Traded Funds (ETF): Meaning | Benefits

Exchange Traded Funds (ETFs)

An ETF or Exchange Traded Funds means funds that are traded on stock exchanges. Funds mean a pool of money from people. The company that manages that fund is called an Asset Management Company (AMC), and the AMC appoints the fund manager for that fund. Fund managers invest the money according to the goals and objectives of the fund. The profits from that investment are shared among those who had invested in that fund. And to manage the fund, the AMC charges some fees, which is called the expense ratio.

Most Exchange Traded Funds are passive instruments, and they closely track an Index. Being passively managed makes ETF expense ratio far less than mutual funds. Apart from low-cost, ETFs also offer increased transparency, no exit loads, and instant liquidity. As most ETFs track an index, it should not outperform or underperform an Index. These are re-balanced when the Index is re-balanced.

Exchange Traded Funds (ETFs) can be of various types. For example, Index ETF, Stocks/Sectoral ETF, Bonds ETF, Currency ETF, Commodities ETF like Agriculture, Metal, Gold, etc. The most popular is the Index ETF and Gold ETF. Index ETF can be of Nifty, Sensex, or other indices.

What makes ETFs Popular and Unique?

When the entire economy in the world collapsed in 2008, investors started questioning active management. In 2007, the world’s famous investor Mr. Warren Buffet even bet that Index Funds like S&P 500 will beat active management funds in 10 years, and guess what, he was right. The underperformance of actively managed funds against Index has resulted in investors’ shift from active to passive investment. While passive mutual funds have their own benefits, ETFs gained more popularity over them due to their tradability, transparency, and low costs.

You can invest in an ETF, which is a fraction of the cost and gets exposure to a particular security. Let’s assume you have to buy the Nifty Index, which means you have to buy all the 50 stocks present in Nifty, which will cost you more than Rs 1 lakh. But you can buy one unit of Nifty ETF with just Rs 100 and get exposure to the Nifty Index.

Advantages

1. An ETF is a basket of different stocks or different securities together. It’s a portfolio by design that makes it diversified and a lot less risky.
2. ETFs in India are mirror indices. For example, a Nifty ETF mirrors the Nifty Index and tracks the performance and the movement of the Index itself. Similarly, the Gold ETF tracks the gold prices. Hence if Nifty moves up by 2%, your ETF also moves up by 2% and vice versa, making ETFs more transparent, i.e., what you see is what you get.
3. You can easily buy and sell an ETF in real-time as they are traded on the stock exchange. For example, you can buy and sell an ETF anytime during market hours and get the advantage of price movement.
4. You can start with a very low minimum investment amount. For example, you can buy a Nifty ETF at Rs 100 and a Gold ETF at Rs 40.
5. As there is no role of the fund manager, its expense ratio is very less.
6. No account other than Demat, Trading, and Bank account required.
7. You can take advantage of arbitrage, i.e., buy at a low price in the exchanges and sell it at high prices in Futures.

Disadvantages

1. Due to lack of liquidity, there is not much trading in ETF.
2. Brokerage fees have to be paid to the Broker for trading an ETF.
3. SIP in ETFs isn’t as convenient as they are with mutual funds.
4. There are not many ETFs available in India, and ETFs’ current offering is very limited. However, this will change as ETFs become more popular, and ETFs adoption increases in India.

ETF vs. Mutual Funds

• ETFs can be easily bought and sold in the exchange by the investors who have a Demat and trading account. In contrast, in mutual funds, an application is required to be submitted to the Asset Management Company.
• ETF is bought and sold in real-time and at the unit price, but Mutual Funds are bought and sold at NAV, which is decided at the end of the day.
• ETF is a combination of mutual funds and stocks. Like mutual funds, people pool their money together in a fund that invests in different instruments like stocks, bonds, and other securities. Like a single stock, ETF can be bought and sold in exchanges anytime during market hours.
• ETFs have tracking errors, i.e., the difference between the index return and fund return. But this can happen with the mutual fund also tracking an index.
• Both MFs and ETFs are a diversified basket of securities such as Stocks, Golds, Bonds, etc. In both the instruments, people pool their money together. A fund manager decides on their behalf as to which stocks to be added or removed to help you gain profits. At the same time, mutual funds are usually active, where the fund manager decides which stocks to invest in and when. ETFs track an Index similar to index funds. They allow investing in popular indices like the Nifty 50 and select the same shares exactly in the same proportion as they are in the Index.

These were the major comparative points between ETFs and Mutual Funds, and both the instruments have their pros and cons. It is up to you in which instrument you want to invest.

Tax implications on Equity ETF

• While trading in ETF, you have to pay Securities Transaction Tax (STT).
• 15% STCG tax will have to be paid on investment for less than one year.
• No tax will have to be paid on profits up to Rs 1 lakh in the long term.
• 10% LTCG tax will have to be paid on profits over Rs 1 lakh.

Tax implications on Gold ETF

• Investments under 3 years will be taxed according to the tax slabs.
• Investments over 3 years will get the benefit of indexation. There will be a 20% tax after indexation, and a 10% tax will be levied without indexation.

Conclusion

Exchange Traded Funds (ETFs) are low-cost investment products which can be used to take long term exposure in market indices like Nifty, Sensex, Bond, Gold, etc. It can also be used for short term exposure. Investors can enter and exit at intraday market levels and get the advantage of price movement in the day. Exchange Traded Funds (ETFs) can also be used to create model portfolios as per the risk profile of an investor.

Also Read:

• Market Capitalization
• Financial Markets
• Types of Shares in the Stock Market