One may consider active and passive investment products when one plans to invest in financial markets. Active investment products are those where the investment portfolio is being managed actively, with the professional fund management team taking investment decisions after research and due diligence. The objective of an actively managed scheme is to generate alpha, i.e. returns over and above market benchmarks.
In contrast, passive investment products are not managed actively, but investment decisions are driven by changes in the underlying index which the scheme tracks. Such passively managed schemes aim to generate market returns in line with the underlying index. ETF (Exchange Traded Fund) is one such passive investment option.
Exchange Traded Funds (ETFs) offer direct investment exposure to their underlying indices or commodities like silver, gold etc. As per Securities and Exchange Board of India (SEBI) Guidelines, an ETF must deploy at least 95% of its assets in securities of the underlying index. The article discusses how ETFs work and how investors can invest in ETFs.
How do ETFs work?
ETFs combine the underlying investment principles of equity shares and mutual funds. Just like mutual funds pool investors' money and create an investment portfolio, ETFs also create an investment portfolio that mirrors the underlying index's composition. Changes in the valuation of ETF units depend upon the changes in the valuation of the underlying investment portfolio.
The fund management team is mandated to implement future changes in the index composition as and when they happen. However, there might be some time lag in implementing the changes when they happen and implemented in the investment portfolio, leading to slightly different investment returns during that period. Such differential is referred to as the tracking error.
Similarly, while equity shares tend to carry an underlying book value, the market price of shares depends upon several underlying factors like earnings growth, brand value etc. Similarly, the trades of such ETF units on stock exchanges don't happen at Net Asset Value (NAV) per unit declared by the mutual fund house daily. The price of exchange trades on stock exchanges depend upon the Demand and supply of the units at a particular point of time.
So, if an investor is looking to buy ETF units, someone else should be looking to sell the units at the same rate. Similarly, if an investor wants to sell ETF units, there should be a buy order at the same price for order execution.
One can trade in ETF units over stock exchanges like other equity shares. To invest in ETFs, one must place a buy order on stock exchanges through a Demat trading account, which can be 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. One may consider investing in such ETFs, which have a larger volume on stock exchanges. Higher liquidity for ETF units enables the investors to have a higher probability of trade execution at the stock exchanges with lower impact costs.
Further, AMCs are also mandatorily required to appoint Authorised Participants (AP)/market Makers (MM) to ensure ETF liquidity on stock exchanges. The role of AP/MM is to provide two way quotes at reasonable spreads across market working hours.
Taxation of gains from ETF units
The gains earned by the investors from selling ETF units 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 |
Disclaimer-
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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.
