<p>One may invest in equity markets by following the two investment strategies – active or passive. While active investing requires careful stock selection in the investment portfolio, passive investing refers to mirroring the benchmark index entirely.</p>
<p>In passive investment products, <a href="https://www.utimf.com/about/key-people/fund-managers/">fund managers</a> do not have any discretion to invest outside the index constituents or deviate from the index weightage of different index constituents. It helps investors eliminate unsystematic risk from investment plans. Unsystematic risk is unique to an individual company or sector. While the investors can’t invest directly in the benchmark indices, an Exchange Traded Fund (ETF) makes it convenient for them to have similar investment exposure.</p>
<p><a href="https://www.utimf.com/mutual-fund-products/etfs/">Exchange Traded Funds</a>, commonly referred to as ETFs, are like mutual funds. However, they track the underlying index with the intent to replicate its performance for the investors. So, if the underlying index moves by 15% in a year, an ETF tracking the index will generate similar returns for its investors (less the expenses). As such, investing in ETFs allows direct investment exposure to a popular index like BSE Sensex, Nifty50, Nifty Next50 etc.</p>
<p>Unsystematic risk refers to the risk of making a wrong selection for the investment portfolio. While the investors can’t invest directly in the benchmark indices, an Exchange Traded Fund (ETF) makes it convenient for them to have similar investment exposure.</p>
<p><img alt="" height="520" src="https://doc.utimf.com/v1/AUTH_5b9dd00b-8132-4a21-a800-711111810cee/UTIC…(882(w)X520(h)-pixels)20190508-113405.jpg" width="882" /></p>
<h2 style="font-size:21px;">Meaning of Exchange Traded Funds: What is an Exchange-Traded Fund (ETF)?</h2>
<p>ETFs are such securities which aim to track an underlying index through a passive investment strategy. ETF units are tradable on stock exchanges like equity shares, etc., and their investment portfolio replicates the composition of such underlying index. So, if the underlying index moves by 15% in a year, an ETF tracking the index will generate similar returns for its investors (less scheme expenses).</p>
<h2 style="font-size:21px;">Types of ETFs</h2>
<p>ETFs can be broadly categorised into three categories depending on the asset class they are tracking:</p>
<h3 style="font-size:18px;">Equity ETFs</h3>
<p>Equity ETFs may track different benchmark equity indices, including but not limited to NSE Nifty 50, S&P BSE Sensex, Nifty Midcap100, etc. ETFs may also track international equity indices like NASDAQ, Hang Seng etc., providing a convenient investment option to invest overseas.</p>
<h3 style="font-size:18px;">Debt ETFs</h3>
<p>Debt ETFs track indices comprising debt securities like PSU Bonds, SDL Index etc.</p>
<h3 style="font-size:18px;">Commodity ETFs</h3>
<p>Commodity ETFs track the prices of physical commodities, like Gold ETF etc.</p>
<h2 style="font-size:21px;">Why invest in ETFs?</h2>
<p>Investing in ETFs allows the investors to have direct investment exposure to popular indices like S&P BSE Sensex, Nifty50, Nifty Next50 etc. Another essential feature of an ETF is that the fund managers don’t have the flexibility to go beyond the index securities or deviate from the weights. Given the limited role of fund managers in managing passive funds, such schemes carry low fund management changes. This results in the Total Expense Ratio (TER) of ETFs to be lower, thereby providing a cost- efficient investment option to the investors.</p>
<h2 style="font-size:21px;">How do Exchange Traded Funds (ETFs) work?</h2>
<p>ETFs are like other mutual funds, the only difference being investment strategy. While actively managed mutual funds are managed through an active investment strategy with fund managers taking the investment decisions, ETFs track a specific underlying index. Here is how an ETF typically works:</p>
<ol>
<li><b>Creation of ETF Units</b> – The mutual fund creates ETF units with securities in the same weights as the underlying index. These units are listed on stock exchanges for buying and selling by investors.</li>
<li><strong>Trading of ETF Units through Stock Exchanges</strong> – You may invest in ETF units by putting buy/ sell orders for ETF units through the stock trading account. The units will be credited/debited to/from your Demat account, just like normal stocks.</li>
<li><strong>Valuation Changes of ETF Units</strong> – Since the underlying investments for the ETF units is the investment portfolio tracking the underlying index, any changes in the value of the investment portfolio will drive the changes in the NAV of the ETF units. However, there may be some variation due to the demand and supply of ETF units on an exchange, etc.</li>
</ol>
<h2 style="font-size:21px;">Benefits of ETFs for beginners:</h2>
<p>Features of Exchange Traded Funds or ETFs are given below:</p>
<h3 style="font-size:18px;">1. Lower costs</h3>
<p>Since the ETFs are passively managed, the investment and fund management team only need to track the underlying index and implement the changes whenever they happen. There is no flexibility for the fund manager to deviate from the index weight, then that of the underlying index. Therefore, ETFs tend to have lower expense ratios than actively managed funds.</p>
<h3 style="font-size:18px;">2. Elimination of unsystematic risk</h3>
<p>Investment risk is classified into two categories – systematic and unsystematic. Systematic risk refers to the broader market risks, which is the risk of movements in the equity markets due to changes in the macroeconomic environment.</p>
<p>On the other hand, unsystematic risks are the risks which are specific to the specific investment option, i.e., the select <a href="https://www.utimf.com/mutual-fund-schemes/">mutual fund scheme</a>. ETFs only carry the systematic risk, since they replicate the market indices and to some extent, the risk of tracking error, which means the time gap between the time changes are implemented in indices and when the changes are made effective in the ETF portfolio. As such, investors may use ETFs to eliminate unsystematic risk in their portfolio effectively by planning ETF investment strategies.</p>
<h3 style="font-size:18px;">3. Diversification</h3>
<p>Since the underlying indices are constructed after adequate research and back-testing of data, they encapsulate different market sectors and segments within the same index. Investing in ETFs provides the same diversification across the market segments to the investors.</p>
<h3 style="font-size:18px;">4. Liquidity</h3>
<p>Since the ETF units are listed on recognised stock exchanges, the investors may liquidate their investments at any point during the exchange trading hours.</p>
<h2 style="font-size:21px;">Disadvantages of ETF</h2>
<p>While ETFs are preferred investment options with passive investing strategy, here are the disadvantages of ETFs:</p>
<h3 style="font-size:18px;">Liquidity</h3>
<p>Investors can undertake transactions in ETFs only through stock exchanges. As such, the transactions are contingent on sufficient market depth for such orders on stock exchanges. If there are not enough sellers for the ETF units at a given price, one may not be able to buy ETF units at the prevailing price. Similarly, if one needs to liquidate their ETF investments, but there are no buyers for ETF units at the market price, one will not be able to liquidate their investments.</p>
<h3 style="font-size:18px;">No alpha generation</h3>
<p>Fund managers for ETFs are only required to track the investment portfolio to replicate the composition of the underlying index. The investment portfolio will always mirror the underlying index. As such, the ETF returns will emulate the returns generated by the underlying index.</p>
<p>The fund cannot outperform the benchmark index, and thus, there will be no alpha generation for the investors. However, ETFs can still be considered by investors who rely on the broader market wisdom and are content with the benchmark returns.</p>
<h3 style="font-size:18px;">Can be held only in Demat</h3>
<p>ETFs can be held only in Demat accounts, and one cannot invest in ETF units through <a href="https://www.utimf.com/">mutual fund</a> houses or physical submission of the application form for investor folio. Owing to these inherent limitations, not all investors are inclined to invest in ETFs.</p>
<h2 style="font-size:21px;">How to invest in ETF?</h2>
<p>ETFs are listed on a stock exchange, and thus, they may be traded in the same way as an equity share. The investors may buy/ sell ETF through their Demat trading accounts by placing a bid for purchasing the units at market price or the limit price. A limit price order gets executed if the market price of the ETF units touches or goes below the limit price. Furthermore, investors may only hold such units in their Demat accounts.</p>
<h2 style="font-size:21px;">ETFs vs Index Funds</h2>
<p>While both ETFs as well as <a href="https://www.utimf.com/mutual-fund-products/equity-funds/uti-nifty-index… funds</a> are passive investment products, here is a brief comparison between the two:</p>
<h2 style="font-size:21px;">Taxation of ETFs</h2>
<p>The taxation of ETF units is dependent upon the underlying index. If the underlying index is an equity index, the taxation will be in line with the tax treatment for equity shares, where any short-term gains (with an investment period of less than 12 months) are taxed at 15% (plus applicable cess and surcharge) and the long-term capital gains are taxed at 10%. Such long-term capital gains are also exempt up to ₹1 lakh a year and only gains beyond ₹1 lakh are taxable.</p>
<p>Considering the transparency embedded within the ETF as an investment product and its lower cost of investing, ETFs mays be considered by investors who are willing to stay content with the broader market indices’ returns and are not running for the alpha-generating mutual fund schemes.</p>
<h2 style="font-size:21px;">How to buy and sell ETFs</h2>
<p>ETFs are listed on a stock exchange, and thus, they may be traded in the same way as an equity share. One can invest or sell ETFs in the same manner as they are doing for stocks. To invest in ETFs, one needs to place a buy order on the stock exchange through the Demat trading account. The order must specify the quantity of ETF units being offered to buy/ sell and the price at which the investor is offering to buy or sell.</p>
<p>As such, the order may be a market order or limit order. A market order means that the order would be executed at whatever the prevailing market price is. In contrast, a limit order specifies the maximum buying/ minimum selling price at which the investor is willing to buy or sell the ETF units.</p>
<p>In case the market price reaches the specified limit price, the order is executed. However, if the specified limit price is not touched, the order is cancelled at day end, and the investor will need to place another order on the next trading day if required. Further, such units may be held by the investors only in their Demat accounts.</p>
<p>ETF Need to be more vigilant about the process and revise the existing process in conjunction with the compliance teams and create more content for general awareness of passive offerings creation and redemption.</p>
<p>At the time of the initial NFO (New Fund Offer) for ETF, the money invested by the investors is pooled, and an investment portfolio is created, which mirrors the composition of the underlying index. The entire investment is bifurcated into ETF units with face value of Rs. 10 each. Once such ETF units are listed post initial allotment, the NAV of the ETF units changes every day. Further, the demand and supply of such ETF units on stock exchanges also determine the real trading price of such units.</p>
<p>When an investor places an order for ETF units on stock exchanges, the ETF units only change hands from one investor to another and there is no change in the overall ETF portfolio. However, sometimes mutual funds act as market makers for the ETF units. As such, they create fresh ETF units at the NAV and provide a supply of such ETF units on stock exchanges for the investors to buy.</p>
<p>Similarly, the mutual funds may buy the ETF units on the stock exchange in case of a higher supply of such units and extinguish such units at NAV. Both actions by the mutual fund houses do not otherwise impact the existing investors but just aim to balance the demand-supply of such ETF units on stock exchanges.</p>
<h2 style="font-size:21px;">Gold ETF vs Gold Funds</h2>
<p>An ETF tracking the gold prices in international market is called Gold ETF, while an index fund tracking the commodity is called Gold fund. While the common link between <a href="https://www.utimf.com/mutual-fund-products/etfs/uti-gold-exchange-trade… ETF</a> and Gold Funds is that both these are passive investment options, the differences between ETF and Index funds as discussed in the above paragraphs are equally applicable for Gold ETFs and Gold funds.</p>
<h2 style="font-size:21px;">How to find the right ETFs for your portfolio</h2>
<h3 style="font-size:18px;">Underlying Benchmark</h3>
<p>While one may consider all ETFs to be equal being passive investment options, the underlying benchmark being tracked might make a lot of difference. An ETF may track a large cap index like NSE Nifty50, or a small cap index like CNX Small cap 100 or debt indices like SDL index, etc.</p>
<p>All the indices carry the respective risk-reward trade-offs and remain suitable for investors with different risk appetites. One should choose the right index benchmark before zeroing in on the right ETF tracking that index.</p>
<h3 style="font-size:18px;">Average Daily Turnover</h3>
<p>Once the investor has selected the suitable index benchmark, one should then review the average daily turnover of different ETFs tracking that index. The liquidity of ETF units on stock exchanges is crucial parameter for an investor, since in the absence of sufficient daily turnover, an investor may not be able to buy or sell the ETF units at the market prices and forced to trade at off-market rates to generate sufficient demand. This difference between the market value and the transaction value is referred to as the impact cost.</p>
<h3 style="font-size:18px;">Total Expense Ratio (TER)</h3>
<p>Since scheme expenses is charged to the ETF returns, a higher expense ratio directly impacts the investor returns. As such, in case of two ETFs tracking same benchmark index, the returns of the fund with higher TER will be lower. Thus, one should prefer investing in ETF with lower TER.</p>
<h2 style="font-size:21px;">Final word</h2>
<p>ETFs thus emerge as an attractive investment option for the investors who seek investment exposure towards the benchmark indices, instead of relying upon the fund managers&#39; selection of stocks. As such, investor may consider investing in ETFs for emulating the returns generated by the underlying indices in a cost-effective manner. Additionally, it is convenient to invest in ETFs sitting at the comfort of home, as the investments must be done online through stock exchanges.</p>
<p><strong>Disclaimers</strong>: The information set out above is included for general information purposes only and is not exhaustive and does not constitute legal or tax advice. In view of the individual nature of the tax consequences, each investor is advised to consult his or her or their own tax consultant with respect to specific tax implications arising out of their participation in the Scheme. Income Tax benefits to the mutual fund & to the unit holder is in accordance with the prevailing tax laws/finance bill 2017. Any action taken by you on the basis of the information contained herein is not intended as on offer or solicitation for the purchase and sales of any schemes of UTI Mutual Fund. Please read the full details provided in SID and SIA carefully before taking any decision.</p>
<p><strong>Mutual Fund investments are subject to market risks, read all scheme related documents carefully.</strong></p>
<p>UTI AMC Ltd is not an investment adviser, and is not purporting to provide you with investment, legal or tax advice. UTI AMC Ltd or UTI Mutual Fund (acting through UTI Trustee Company Pvt. Ltd) accepts no liability and will not be liable for any loss or damage arising directly or indirectly (including special, incidental or consequential loss or damage) from your use of this document, howsoever arising, and including any loss, damage or expense arising from, but not limited to, any defect, error, imperfection, fault, mistake or inaccuracy.</p>