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With the evolution of financial markets, people may find themselves flooded with several options for investing their savings. These include fixed/recurring deposits, mutual funds, government bonds, stocks, etc. Among these options, investing in benchmark indices may pose a transparent investing strategy to equity investors, as they will be exposed towards a pre-defined basket of stocks.
Since people can't directly invest in indices like tradeable securities, they may opt for a similar investment exposure by investing in Exchange Traded Funds (ETFs). These funds work as a simplified investment option. ETFs are specific Mutual Fund offerings that track an underlying index, such as NSE Nifty50, S&P BSE Sensex, Nifty Midcap100 etc. As the name suggests, ETF units can be purchased and sold over stock exchanges just like any other stock.
While active investing requires prudent investment decisions by the fund manager, passive investing options like ETFs replicate the benchmark index completely with similar portfolio stocks and weights. Generally, fund managers don't have the flexibility to invest outside the index constituents or deviate from their specific weightage.
As per the Securities and Exchange Board of India (SEBI) Guidelines, an ETF must deploy at least 95% of its assets in securities of the underlying index. Thus, when investing in an ETF, investors rely on the performance of the underlying index and not necessarily on the fund manager's investment decisions.
Benefits of ETF investing
1. Easy to understand
Indices are generally defined & rule-based. They may be primarily discussed and analysed in the formulation phase. Understanding indices and their performance may be simple and more straightforward for some investors. Hence it may be easier for investors to understand ETFs as an investment option. Further, since the mandate of such ETFs is to replicate indices continuously, the investment returns are likely to mirror the returns generated by the underlying index, subject to tracking error and expenses.
2. Cost-effective
The fund manager tracks the index's changes and replicates the same in the fund portfolio. They cannot choose any additional security or deviate from the specific weights of existing securities on their own.
This translates to lower fund management expenses than actively managed funds; ultimately leading to better cost-effectiveness for investors.
3. Reduction of unsystematic risks
Investment risks can be broadly categorised into systematic and unsystematic. Systematic risks arise due to changes in the external environment, like changes in laws, macroeconomic factors, etc. In contrast, unsystematic risks may occur due to certain investment decisions.
While systematic risks are universal, unsystematic risks may be attributed to different reasons. Since ETFs are passive investment products and fund managers have no discretion in managing the fund per se, ETFs may eliminate particular unsystematic risks from the investment strategy.
Investing in ETFs
Since ETFs are traded over the stock exchanges, one needs to hold a trading/demat account to invest in ETFs. They need to place a buy order on the stock exchanges, just like they are purchasing any other stock.
The buying and selling price for the ETF unit may be different from the Net Asset Value (NAV) of the ETF, as the traded price on the stock exchange depends upon the demand and supply of such units on the stock exchange floor.
The bid-ask spread, or in simple words, the spread between the buy and sell price, depends on the liquidity of such units on stock exchanges. The higher the liquidity of ETF units, the closer will be the traded price to the prevailing market value of such ETF units.
Taxation of ETFs
ETFs may be categorised as equity ETFs and non-equity ETFs depending upon the underlying benchmark index. When ETFs replicate equity indices, the units are taxed like other equity shares. Accordingly, the specified period for classifying gains as Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG) is 12 months.
Gains from equity ETF investments held for less than 12 months are classified as STCG with a tax rate of 15%. Gains from investments held for 12 months or more are taxed at 10% after an exemption of Rs. 1 lakh in a financial year towards LTCG on equity shares and equity funds taken together.
For ETFs replicating debt indices or commodities, the units are taxed as non-equity funds. As such, 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.
In conclusion, ETFs may pose as an attractive investment option for investors seeking exposure to the benchmark indices instead of relying solely on other investment strategies.
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. 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.
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.
