Exchange-traded funds allow investors to gain exposure to a basket of securities through a single transaction on a stock exchange. Knowing what ETFs are begins with understanding how they combine the pooled investment structure of a mutual fund scheme with the real-time trading features of a listed share.
Understanding the advantages and disadvantages of ETFs involves looking beyond expense ratios. Liquidity, bid-ask spreads, tracking difference, taxation and the need for a demat account can all influence an investor’s experience and realised returns.
Table of Contents
What is an ETF?
An exchange-traded fund, or ETF, is a mutual fund scheme whose units are listed and traded on a stock exchange. An ETF may provide exposure to an index comprising equities, debt securities, commodities or another defined basket of assets. Each unit represents a proportionate interest in the scheme’s underlying portfolio.
Most ETFs in India follow a passive investment strategy. Instead of selecting securities with the aim of outperforming a benchmark, the portfolio generally seeks to replicate an index, subject to expenses, tracking error and tracking difference.
ETFs and index funds may follow similar benchmarks, but their transaction mechanisms differ. ETF units trade at market prices during exchange hours, while index mutual fund transactions are generally processed at the applicable end-of-day NAV.
Key Takeaways
- ETFs provide exposure to a basket of securities while allowing units to be traded on a stock exchange during market hours.
- Their main benefits include diversification, a rule-based investment approach, intraday trading and relatively lower expense ratios in many passive categories.
- Key ETF risks include market movements, tracking difference, limited liquidity, bid-ask spreads and premiums or discounts to NAV.
- The total cost of investing may include the expense ratio, brokerage, statutory charges, demat expenses and the bid-ask spread.
- An ETF’s suitability depends on its underlying index, liquidity, tracking record, costs and alignment with the investor’s goals and risk appetite.
How do ETFs work?
An ETF invests according to the composition or methodology of its chosen benchmark. When the benchmark changes, the fund manager adjusts the portfolio so that the scheme continues to track it as closely as practicable.
Three values are particularly relevant:
- NAV: The per-unit value of the ETF’s underlying portfolio, calculated according to mutual fund valuation rules.
- Indicative NAV or iNAV: An indicative per-unit value based on the current market value of the portfolio during trading hours. Under SEBI requirements, it is disclosed continuously on the stock exchange where the ETF is listed.
- Market price: The price at which ETF units are available for purchase or sale on the exchange. It is influenced by buy and sell orders and may be above or below the NAV or iNAV.
Authorised participants and market makers provide buy and sell quotes and support the creation and redemption process. This mechanism may help keep an ETF’s market price closer to its underlying value. Temporary premiums, discounts or wider bid-ask spreads can still occur, particularly during volatile or less liquid market conditions.
Retail investors generally invest through stockbrokers using demat and trading accounts.
Advantages of investing in ETFs
The exchange traded funds advantages and disadvantages largely arise from their diversified portfolio structure and exchange-based trading mechanism.
Diversification through one investment
An ETF can provide exposure to several securities through a single purchase, reducing dependence on the performance of one company.
Relatively lower expense ratios
Since most ETFs follow a passive, rule-based strategy, they may have relatively lower expense ratios than many actively managed mutual funds.
Intraday trading flexibility
ETFs can be bought or sold at prevailing exchange prices during market hours. Investors may also use limit orders to exercise greater control over the execution price.
Rule-based portfolio construction
A passive ETF follows the methodology of its underlying index, including its security selection, weighting and rebalancing rules.
Regular disclosures
Investors can review the ETF’s NAV, iNAV, portfolio, expense ratio, tracking error and tracking difference through disclosures made by asset management companies, stock exchanges and AMFI.
Access to different asset classes
ETFs may provide exposure to broad equity indices, sectors, government securities, commodities and other market segments. This can help investors include a particular asset class in their asset allocation without purchasing each underlying security separately.
Disadvantages and risks of ETFs
The main disadvantages of ETFs include market risk, limited liquidity, tracking deviations and costs associated with exchange-based transactions.
Market risk
An ETF’s value changes with the index or assets it tracks. Equity ETFs, debt ETFs, gold ETFs and silver ETFs are therefore exposed to the risks affecting their respective underlying asset classes.
Liquidity risk and bid-ask spreads
A less actively traded ETF may be difficult to transact at the expected price and may have a wider bid-ask spread. Liquidity depends on trading activity, market depth, market-maker participation and the underlying assets.
Premium or discount to NAV
An ETF trades at a premium when its market price is above its NAV or iNAV and at a discount when it is below. The difference may widen during volatile or less liquid market conditions and affect the price paid or received.
Tracking error and tracking difference
- Tracking error is the annualised standard deviation of the difference between the ETF’s daily returns and its benchmark’s daily returns.
- Tracking difference is the annualised return gap between the ETF and its benchmark over a stated period.
Expenses, cash holdings, rebalancing, transaction costs and valuation timing may affect both measures.
Source: SEBI Master Circular for Mutual Funds dated 20 March 2026.
Trading and account-related costs
ETF investors may incur brokerage, bid-ask spreads, demat charges, price impact and applicable exchange and statutory levies, including securities transaction tax where relevant. These costs can have a greater effect on small or frequent transactions.
Concentration risk
Sectoral, thematic and strategy-based ETFs may hold concentrated portfolios despite investing in several securities. Multiple ETFs may also contain overlapping companies or sectors.
Limited scope to outperform the benchmark
A passive ETF seeks to replicate its benchmark rather than outperform it through active security selection. Its return may be lower than the benchmark after expenses and tracking difference.
Risk of overtrading
Real-time pricing may encourage frequent decisions based on short-term market movements, increasing brokerage and spread costs.
ETF vs mutual funds: Key differences to consider
ETFs and traditional open-ended mutual funds both pool investor money, but they differ in how units are priced, purchased, held and redeemed:
| Factor | Exchange-traded funds (ETF) | Traditional open-ended mutual funds |
| Trading mechanism | Bought and sold on a stock exchange during market hours | Purchased or redeemed through the fund house or an investment platform |
| Transaction price | Prevailing market price, which may differ from NAV | Applicable end-of-day NAV, subject to cut-off and realisation rules |
| Demat and trading accounts | Generally required for retail exchange transactions | Not required when units are held in statement-of-account form |
| Investment approach | Most ETFs follow a passive benchmark-tracking strategy | May be actively or passively managed |
| Costs | Expense ratio, brokerage, bid-ask spread and applicable transaction charges | Expense ratio and any applicable exit load |
| Liquidity | Depends on market activity, market makers and the liquidity of underlying assets | Purchases and redemptions are generally processed by the mutual fund at the applicable NAV |
| Systematic investing | Periodic purchases may be scheduled through some brokers, but execution takes place on the exchange | A systematic investment plan facility is commonly available through AMCs and investment platforms |
| Disclosures | ETF-specific information includes iNAV and tracking measures | Portfolio and scheme information is disclosed according to applicable SEBI requirements |
| Order control | Investors may use market or limit orders during trading hours | Investors cannot select an intraday execution price |
| Minimum transaction | Generally based on the market price and permitted lot size of the ETF units | Based on the scheme’s stated minimum investment amount |
| Investment objective | Usually seeks to replicate a benchmark, subject to tracking error and expenses | Active funds may seek to outperform their benchmarks, while passive mutual funds seek to track them |
Neither structure is automatically better. The relevant comparison is between schemes offering similar exposure, after considering total costs, liquidity, convenience, risk and the role each investment will play in the portfolio.
How are ETFs taxed in India?
The tax treatment of ETF gains depends on the assets held by the scheme and whether it qualifies as an equity-oriented fund under the Income-tax Act.
| ETF category | Short-term treatment | Long-term treatment |
| Equity-oriented ETFs | Units held for 12 months or less are generally taxed at 20%, subject to applicable conditions | Units held for more than 12 months are generally taxed at 12.5% on aggregate eligible long-term gains exceeding ₹1.25 lakh in a financial year |
| Gold ETFs and silver ETFs | Listed units held for 12 months or less are generally taxed at the investor’s applicable slab rate | Listed units held for more than 12 months are generally taxed at 12.5% without indexation |
| Debt-oriented ETFs covered by Section 50AA and acquired on or after 1 April 2023 | Gains are deemed short-term and taxed at the applicable slab rate | Long-term capital gains treatment is not available for covered units acquired on or after 1 April 2023 |
From 1 April 2026, the definition of a specified mutual fund under Section 50AA broadly covers funds that invest more than 65% of their total proceeds in debt and money-market instruments, along with qualifying fund-of-funds structures.
The applicable treatment can vary according to the ETF’s portfolio, acquisition date, investor category and prevailing tax law.
The tax information in this article is based on prevailing laws at the time of publishing the article and is subject to change. Please consult a tax professional or refer to the latest regulations for up-to-date information.
Source: Income Tax Act, 1961, Sections 2(42A), 50AA, 111A, 112 and 112A, read with the applicable amendments under the Finance (No. 2) Act, 2024; Income Tax Department, Government of India.
What to check before investing in an ETF
Before investing, consider the following:
- Underlying index: Review what the index tracks, how its constituents are selected and how often it is rebalanced.
- Portfolio concentration: Check the weights assigned to the largest securities, sectors or issuers.
- Expense ratio: Compare the ongoing cost with other ETFs tracking the same or a similar benchmark.
- Tracking record: Review both tracking error and tracking difference.
- Trading liquidity: Examine trading volume, market depth and the usual bid-ask spread rather than relying on AUM alone.
- Market price relative to iNAV: A material premium or discount may affect the transaction outcome.
- Underlying asset liquidity: Consider how readily the securities or assets held by the ETF can be traded.
- Total transaction cost: Include brokerage, statutory charges, spreads and demat-related expenses.
- Tax treatment: Confirm the ETF’s tax classification.
- Portfolio fit: Check whether the ETF adds useful exposure or duplicates investments already held through other funds.
10 ETF concerns investors should not overlook in 2026
ETF risks can vary according to the underlying index, portfolio and trading conditions. These are the key concerns investors should assess:
1. Market risk
An ETF’s value moves with its underlying index or asset class and may decline during unfavourable market conditions. Diversification does not protect against a broad market fall.
2. Liquidity risk
Low trading activity or limited market depth may make it difficult to buy or sell ETF units at the expected price. Liquidity may weaken further during volatile markets.
3. Bid-ask spread
The difference between an ETF’s buying and selling prices represents an indirect transaction cost. Wider spreads can increase the cost of entering or exiting the investment.
4. Premium or discount to NAV
An ETF’s market price may be higher or lower than its NAV or iNAV. A substantial difference can affect the price paid or received by the investor.
5. Tracking error and tracking difference
Tracking error shows how consistently an ETF follows its benchmark, while tracking difference measures the return gap between them. Expenses, cash holdings, rebalancing and transaction costs can affect both measures.
6. Total cost of investing
ETF costs may include the expense ratio, brokerage, statutory levies, demat charges and bid-ask spread. These costs can have a greater effect on small or frequent transactions.
7. Portfolio concentration
Sectoral, thematic and strategy-based ETFs may hold concentrated portfolios despite investing in several securities. Investors should review the largest holdings and sector weights before investing.
8. Index construction risk
A passive ETF follows its index methodology regardless of market valuations or changing business conditions. The index’s selection, weighting and rebalancing rules therefore directly shape the ETF’s risk and return profile.
9. Limited scope to outperform
A passive ETF seeks to replicate its benchmark rather than outperform it through active security selection. Its return may be lower than the benchmark after expenses and tracking difference.
10. Overtrading and execution risk
Intraday trading may encourage frequent decisions based on short-term price movements. Market orders may also execute at unfavourable prices when liquidity is limited or markets are volatile.
Is an ETF suitable for your portfolio?
An ETF may be suitable for an investor seeking rule-based exposure to an index or asset class and who is comfortable using demat and trading accounts. It may also be considered where intraday execution or exposure to a specific market segment is relevant to the investor’s asset allocation.
The decision should be based on the underlying index, investment horizon, risk appetite, liquidity, tracking record, costs and existing portfolio exposures. Broad-market, sectoral, debt and commodity ETFs can have substantially different risk profiles.
Investors should review the scheme information document, investment objectives, product labelling and riskometer before investing.
Conclusion
ETFs provide diversified, rule-based market exposure with the flexibility of exchange trading. However, market risk, tracking difference, liquidity, bid-ask spreads and transaction costs can affect the return an investor actually receives.
Comparing the underlying index, total cost and trading characteristics is therefore more useful than selecting an ETF solely because it has a low expense ratio.
FAQs
What is an Exchange-Traded Fund (ETF)?
An exchange-traded fund is a mutual fund scheme whose units are listed and traded on a stock exchange. It invests in a basket of securities or assets and generally seeks to track a specified index or benchmark.
What are the main advantages and disadvantages of ETFs?
The main advantages of ETFs include diversification, intraday trading, rule-based investing, regular disclosures and relatively lower expense ratios in many passive categories. Their disadvantages include market risk, tracking difference, bid-ask spreads, liquidity constraints and transaction costs.
What is the biggest disadvantage of an ETF?
A key disadvantage is that the transaction price may differ from the ETF’s underlying value. Limited liquidity, a wide bid-ask spread or a premium to NAV can increase the effective cost of investing.
Are ETFs better than mutual funds?
ETFs are not universally better than mutual funds. They may suit investors seeking intraday trading and control over execution prices, while traditional mutual funds may be more convenient for NAV-based transactions and automated SIP investing.
Are ETFs safe to invest in India?
ETFs are regulated mutual fund schemes, but they are not risk-free. Their value can decline with the underlying index or asset, and investors may also face liquidity, concentration, tracking and trading-price risks.
Are ETFs safer than individual stocks?
A broadly diversified ETF may carry less company-specific risk than an individual stock because its portfolio contains multiple securities. It can still lose value when the wider market falls, while sectoral and thematic ETFs may remain highly concentrated.
What is an ETF’s tracking error?
Tracking error measures how consistently an ETF follows its benchmark. It is the annualised standard deviation of the difference between the ETF’s daily returns and the benchmark’s daily returns. A lower tracking error indicates more consistent tracking.
Why are some ETFs not liquid?
Some ETFs have limited liquidity because investor participation, trading activity or market-maker activity is low. Liquidity can also weaken during volatile markets or when the underlying assets are difficult to trade.
Do ETFs require a demat account?
Retail investors generally need demat and trading accounts to transact in ETF units on a stock exchange. Traditional mutual fund units held in statement-of-account form can be purchased without a demat account.
Are all ETFs taxed like equity mutual funds?
No. Only qualifying equity-oriented ETFs receive equity mutual fund tax treatment. Debt, gold, silver and other non-equity ETFs may follow different tax rules.
Related Searches:
