Exchange Traded Funds (ETFs) are financial products which provide direct investment exposure to benchmark indices and commodities. As per the SEBI Guidelines, an ETF must deploy at least 95% of its assets in securities of the underlying index. ETFs undertake passive investing, and the fund managers replicate the underlying index and implement changes in the investment portfolio as and when the changes happen in the index constitution.
However, they do not have the discretion to deviate from the index securities or their respective weights. In addition, due to passive investing, the fund management charges are also lower for ETFs. This may make ETFs a cost-effective investment option.
ETF returns aim to emulate the performance of the underlying indices, subject to scheme expenses and tracking errors. Thus, ETF investors are relying on the performance of the underlying indices and not on the fund manager's investment decisions.
In the process, they can also mitigate certain investment risks, as unsystematic risks get eliminated with the product design. There are two types of investment risks when investing in financial markets: systematic and unsystematic.
Systematic risks refer to the risk of adverse changes in the 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, and the overall investment risk is lowered.
How to invest in ETFs?
ETF investing is a convenient way of having exposure to benchmark indices. As the name suggests, ETF units can be traded over stock exchanges like other shares. To invest in ETFs, one must place a buy order on a stock exchange through a demat/trading account. Such an order 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.
Since the market price for ETF units depend on the market depth (demand and supply) of such ETF units, the transaction price can be different from the NAV (Net Asset Value) of the ETF. The bid-ask spread, i.e., the spread between the best buy and sell price, is referred to as the impact cost. It depends on the liquidity of such units on stock exchanges.
In the case of ETFs with higher volume and liquidity, the bid-ask spread is likely to be lower. Additionally, the mutual fund houses also act as market makers, subject to SEBI regulations, to ensure the liquidity of ETF units for investors.
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
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.
The specified cut-off period for classifying gains as Short-Term Capital Gains (STCG) and Long- Term Capital Gains (LTCG) for such ETFs is 12 months. Gains from equity ETF units held for less than 12 months are taxed at 15%. Gains from investments held for 12 months or more are taxed at 10% after zero tax on gains amounting to Rs. 1 lakh in a year towards equity shares and equity funds in aggregate.
If the ETFs track debt indices or commodities, such units are taxed as non-equity-oriented funds. For such ETFs, the specified period for classifying gains as Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG) is 36 months. Gains from such ETF investments held for less than 36 months are taxed at the regular tax rates applicable to the investor, while LTCG gains from investments held for 36 months or more are taxed at 20% after the indexation benefit.
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.
Disclaimer:-
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
To know about the KYC documentary requirements and procedure for change of address, phone number, bank details, etc. please visit https://www.utimf.com/servicerequest/kyc. Please deal with only registered Mutual funds, details of which can be verified on the SEBI website under "Intermediaries/market Infrastructure Institutions". All complaints regarding UTI Mutual Fund can be directed towards service@uti.co.in and/or visit www.scores.gov.in (SEBI SCORES portal). This material is part of Investor Education and awareness initiative of UTI Mutual Fund.
