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Exchange Traded Funds (ETFs) are passive investment options that offer direct investment exposure to underlying indices or commodities like silver, gold etc. As per SEBI Guidelines, an ETF must deploy at least 95% of its assets in securities of the underlying index.
Fund managers are mandated to track the specified index and implement changes in the investment portfolio as and when the changes happen in the index constitution. They cannot go beyond the index composition or their respective weights.
Advantages of Exchange Traded Funds
Following are the advantages of investing in ETFs:
- Portfolio diversification
It is often advised to maintain a diversified investment portfolio and not keep all your eggs in one basket. Diversification helps investors to spread the investment risk across different instruments. With ETFs tracking an underlying index, the diversification advantage embedded in the indices is automatically passed on to the ETF investment portfolio. - Ease of understanding
A key benefit of exchange-traded funds is that the investment returns are easy to understand. Benchmark indices are often constructed using back-tested techniques and aimed to be a true representative of the markets. Such indices are often broadly discussed in investor discussions.
An index movement is often more likely to be discussed in social conversations than specific stock price movements. Understanding indices’ performance may be, thus, simpler and more straightforward for investors. Understanding the investment performance is also easier for investors, as ETFs tend to mirror the returns generated by the underlying indices. - Elimination of unsystematic risks
ETFs tend to mitigate unsystematic risks, which get eliminated with the product design. When investing in financial markets, there are two types of investment risks: systematic and unsystematic. Systematic risks refer to the possibiligty of adverse changes in portfolio valuation due to macroeconomic events.
In contrast, unsystematic risks refer to the risk of making a wrong investment decision. Since ETFs follow a passive investing strategy, the unsystematic risk gets eliminated automatically; therefore, the overall investment risk is lowered. - Cost-effectiveness
Since the role of fund managers is limited to managing the investment portfolio, ETFs carry relatively low fund management expenses. This results in ETFs becoming a cost- effective investment option for investors.
Disadvantages of ETF investing
ETFs have been popular investment options amongst investors aiming for direct investment exposure in benchmark indices. However, some investors tend to find ETF investing non-efficient, as the returns mirror the returns generated by the underlying indices.
Since ETF fund managers cannot use their discretion to choose portfolio securities or deviate from the index weightage, investors cannot expect an outperformance or alpha generation from their ETF investments. Additionally, the trades in ETF units are subject to the liquidity of such units on stock exchanges.
Investing in ETF Units
ETF units are traded over stock exchanges like other shares. To invest in ETFs, one may place a buy order on a stock exchange through a Demat or trading account. They can do so through a market order or a limit order.
A market order implies that the buy order for ETF units will be executed at the best available price in the market. In contrast, a limit order means that the investor has placed a limit on the market price for the order. When the market price of ETF units is equal to or lower than the limit price, the limit order gets executed for the investor.
Taxation of Gains from ETF Units
When they invest in Exchange Traded Funds, the gains earned by the investors are taxed as Capital Gains under Income Tax Laws. The categorisation of gains as Short Term and Long Term depends on the ETF investment pattern and holding period of such units. When ETFs track equity indices, the units are taxed like equity-oriented funds, while if the ETFs track debt indices or commodities, such units are taxed as non-equity oriented funds. The summary of the tax rates applicable is given below:
| Classification of ETF | Holding Period | Capital Gain | Tax Rate |
|---|---|---|---|
| Equity-oriented ETF | Less than 12 months | Short-Term Capital Gain (STCG) | 15% |
| 12 months or more | Long-Term Capital Gain (LTCG) | 10% after an exemption of Rs. 1 lakh for LTCG from equity shares and equity funds in aggregate in a financial year | |
| Other than equity- oriented ETF | Less than 36 months | STCG | Regular tax rates |
| 36 months or more | LTCG | 20% with indexation |
Note: The tax provisions mentioned in the article are for illustrative purposes only and are updated as per the Union Budget 2022 presented in the Parliament in February 2022. The tax rates for capital gains are exclusive of the applicable cess and surcharge, and such tax rates will be as per the tax laws applicable on the date of redemption/ sale and not on the date of investment. Please contact your tax advisor for professional tax advice.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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