What is an ETF?
ETF stands for Exchange Traded Fund. As the name suggests, ETFs can be traded on stock exchanges, just like other stocks listed on stock exchanges.
As per the SEBI Guidelines, ETFs must invest at least 95% of their net assets in the underlying index's securities. Thus, ETFs adopt passive investment strategies tracking different indices, viz., equity, debt, or commodities.
There is no discretion available to the fund management team to deviate from the index composition. They can only implement changes happening in the underlying index. With ETFs closely tracking the underlying index, the ETF returns can mirror the returns generated by the underlying index, subject to scheme expenses and tracking errors.
Such a passive investing strategy aims to capitalise on the benchmark index instead of relying on specific companies. While eliminating personal bias in the investing decisions, the fund manager can invest only in the index constituents and in the same proportion as the index. As such, such products generally have lower expense ratios than actively managed investment products due to the relatively lesser role of fund managers in investing decisions. Moreover, since the transaction costs in such funds are low, investing in Exchange Traded Funds (ETFs) provides a low-cost investment option with the potential for better returns.
With the minimal role of the fund manager in investment decisions, ETFs can help eliminate unsystematic risks for the investors. Further, the benchmark indices comprise companies across different sectors with a proven track record and better corporate practices. So, the index investing through ETFs renders diversification benefit to the investors with a single investment product.
While the investors may want to invest in benchmark indices, like S&P BSE Sensex, NSE Nifty50, etc., it is not straightforward. This is because benchmark indices are not a security in themselves but a basket of securities. Therefore, investors can create a portfolio with the same securities and weights as the underlying index to have such exposure.
The investment portfolio will replicate the benchmark index. However, creating such an investment portfolio may require significant investment capital. Keeping the investment portfolio aligned with the benchmark index will require regular review, time, and effort. Alternatively, one can invest directly in ETFs, allowing the investors to invest in market indices conveniently.
How to invest in indices through ETFs?
Investing in ETFs is akin to investing in any other equity share, wherein the shares/ ETF units are traded on stock exchanges. The investors can trade in ETFs by placing buy and sell orders through their trading accounts/Demat account.
The buy order can be a market order or a limit order. A market order implies that the buy order is executed at the best available sell price on the stock exchange. In contrast, a limit order suggests that the investor has set a price limit to complete the order.
Once a sell order is available at a price less than or equal to the specified price limit, the order gets executed. So, while the investor enforces complete control over the buy price in a limit order, there is no certainty for the investors that the order will be executed.
While the ETF unit's NAV is disclosed daily by mutual funds, the actual price may vary due to the liquidity of such ETF units over the stock exchange. The investors can also check the real-time prices of the ETF units on the exchange portal and trade accordingly.
While the underlying portfolio of the ETF provides the Net Asset Value (NAV) valuation for the ETF, the actual market price on the exchange may vary due to demand-supply differences. However, the transparency and convenience of ETF investing make it an attractive investment product. The buy-sell orders at the exchanges happen on a real-time basis when a buy order for investment at a specific price is matched with a sell order by any other seller at the same price. The investors can check the market depth, i.e., the list of available buy-sell orders at the exchange portal and offer to buy and sell ETF units at a specific price.
Mitigation of investment risks through ETFs
When people invest in markets, they are exposed to systematic and unsystematic risks. Systematic risk is the market risk. The broader equity markets are corrected due to certain macroeconomic events leading to a correction in the portfolio valuation, e.g., the recent modification induced by the Covid-19 pandemic outbreak.
Such risks can be mitigated through diversification since the diversified investment strategy allows the investors to spread the risks across different asset classes and market segments.
Unsystematic risks refer to the risk of wrong stock selection, leading to negative returns in the investment portfolio. Since ETFs follow a passive investment strategy, unsystematic risks are automatically eliminated for the investors.
Taxation of ETF returns
When the investors realise their profits on the sale of ETF units, the gains are taxed as Capital Gains under the Income Tax laws, and the tax rate depends upon the composition of the underlying index for the ETFs. ETFs tracking equity indices are classified as equity- oriented ETFs, while all other ETFs fall in the residual category of non-equity-oriented ETFs. The summary of the tax rates applicable to ETFs 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 |
As such, ETFs are a convenient option for investors to invest in market indices cost- effectively.
In conclusion, investing in indices through ETFs may help investors to create a well- diversified portfolio at a low cost, allowing them to achieve their financial goals over time.