Exchange-traded funds (ETFs) allow Indian investors to gain exposure to a market-linked portfolio through a single transaction on a stock exchange. With increasing participation in capital markets and wider access to demat and trading accounts, ETFs are being used as part of diversified investment allocations.
This article explains what ETFs are, how they function, the potential advantages and disadvantages of ETFs, and how they compare with mutual funds in the Indian investment context.
Table of Contents:
- What is an ETF?
- How do ETFs work?
- Advantages of investing in ETFs
- Disadvantages and risks of ETFs
- ETF vs mutual funds- Key differences to consider
- Is an ETF suitable for your portfolio?
What is an ETF?
An exchange-traded fund (ETF) is a mutual fund scheme that typically tracks an index that may comprise equities, debt securities, commodities or other types of assets. Buying an ETF unit represents proportionate ownership in the underlying portfolio held by the scheme.
Unlike traditional open-ended mutual funds that are transacted at end-of-day net asset value (NAV), ETFs are bought and sold on stock exchanges like listed shares. As a result, ETF prices change during market hours based on trading activity.
In India, ETFs are structured as passively managed mutual fund schemes that aim to replicate the performance of a benchmark index, subject to tracking error. This makes them similar to index funds, which are also passively managed. However, while ETFs and index funds follow a similar investment approach, the primary difference lies in how units are purchased, sold, and held.
Also Read: How to Invest in ETFs: Steps & Key Benefits
How do ETFs work?
ETFs follow a passive investment approach where the portfolio mirrors a specified benchmark index. The fund manager primarily adjusts holdings to reflect changes in the benchmark composition rather than attempting to generate returns through active stock selection.
Two important values associated with ETFs are NAV and market price. The NAV reflects the per-unit value of the underlying holdings and is calculated at the end of each trading day. The market price, however, is determined by demand and supply on the exchange and may differ from NAV during trading hours.
Asset management companies publish an indicative NAV (iNAV) throughout the trading session to help investors assess price movements relative to underlying holdings. Market makers and authorised participants contribute to liquidity by facilitating buying and selling activity, which may help ETF prices remain closer to their underlying value, although temporary premiums or discounts may still occur.
Most retail investors transact in ETFs through stockbrokers using demat and trading accounts.
Advantages of investing in ETFs
Some commonly discussed features include:
- Diversification through a single transaction: ETFs provide exposure to a basket of securities within one investment, reducing dependence on the performance of a single company or security.
- Relatively lower expense ratios in passive strategies: Since ETFs generally track an index and follow a rule-based investment approach, expense ratios in passive categories are often relatively lower compared with many actively managed mutual fund schemes.
- Intraday trading flexibility: ETFs can be bought or sold during market hours at prevailing market prices, unlike mutual fund transactions that are executed at end-of-day NAV.
- Rule-based portfolio construction: Because ETFs track published benchmarks, portfolio composition and rebalancing decisions follow index methodology rather than discretionary investment decisions.
Disadvantages and risks of ETFs
Key limitations and risks include:
- Market risk: ETFs remain subject to market risk because their value fluctuates in line with movements in the underlying securities or asset class.
- Liquidity and impact cost: Lower trading volumes in certain ETFs may reduce liquidity. This may lead to wider bid-ask spreads or execution prices differing from the scheme’s NAV, particularly ETFs tracking niche assets or themes.
- Premium or discount to NAV: ETF market prices may trade above (premium) or below (discount) the NAV during periods of market stress or limited liquidity.
- Trading-related costs: Brokerage charges, securities transaction taxes, exchange fees, and demat account expenses may apply when buying or selling ETF units.
- Tracking difference: Tracking difference refers to the variance between an ETF’s returns and those of its benchmark index. Expenses, cash holdings, rebalancing requirements, and market frictions may contribute to this difference.
ETF vs mutual funds- Key differences to consider
ETFs and traditional open-ended mutual funds differ in important ways. Here’s a look at those:
- Trading mechanism: ETFs are bought and sold on stock exchanges throughout the trading day, causing prices to change continuously. Mutual fund units are typically purchased or redeemed at a single NAV calculated after market closing.
- Costs and management approach: ETFs generally follow a passive strategy that may result in relatively lower expense ratios than actively managed mutual funds. Many mutual funds follow an active investment approach involving research and portfolio management decisions, which may influence overall costs.
- Liquidity and timing: ETF investors may choose when to transact during market hours and the price at which orders are placed. Mutual fund transactions are processed at end-of-day NAV, meaning the final execution price becomes known after market closure.
- Account requirements: Investing in ETFs usually requires a demat account and trading account because transactions occur on an exchange. Mutual funds may be purchased directly from asset management companies or through investment platforms without these accounts.
- Transparency: ETF portfolios are generally disclosed daily. Mutual funds disclose portfolio holdings according to SEBI-prescribed disclosure timelines, which may be less frequent.
- Systematic investing: Mutual funds commonly offer systematic investment plan (SIP) facilities that allow automated investing without exchange participation. ETFs do not typically provide direct SIP facilities from fund houses, although investors may place periodic purchase orders through their broker platforms.
- Objective: ETFs (along with passive mutual funds) seek to replicate the performance of their benchmark, subject to tracking error. Actively managed mutual funds, on the other hand, seek to outperform their benchmark in the long run.
Also Read: SIP in ETF: Meaning, Benefits, Challenges & How It Works
Is an ETF suitable for your portfolio?
Whether an ETF may be suitable for an investor depends on individual financial goals, investment horizon, risk appetite, and familiarity with exchange-based trading.
ETFs may be used as part of an overall asset allocation strategy to obtain diversified market exposure through a passive investment approach. Equity ETFs, which typically invest more than 65% in equities, are classified as very high risk investment products and may require a higher risk appetite.
Investors with longer investment horizons may consider ETFs alongside other mutual fund categories when seeking diversified exposure over time. Careful evaluation of liquidity, costs, and tracking characteristics remains important before investing.
Conclusion
ETFs combine mutual fund pooling with stock exchange trading. The potential advantage of ETF structures lies in diversified, rule-based exposure along with intraday tradability and regular portfolio disclosure. At the same time, liquidity conditions, brokerage costs, tracking differences, and market volatility may influence realised investment outcomes. ETF performance remains linked to market movements and is not guaranteed. Investors may consider evaluating scheme documents, risk factors, and investment objectives before making investment decisions.
FAQs
What is an Exchange-Traded Fund (ETF)?
An exchange-traded fund is a SEBI-registered mutual fund scheme that tracks an index, commodity, or asset basket. Buying an ETF unit represents proportionate ownership in the underlying portfolio. ETFs trade on stock exchanges, and their market prices change throughout the trading day.
How do ETFs differ from traditional mutual funds?
ETFs are traded on exchanges during market hours, so prices fluctuate in real time. Mutual funds are typically bought or redeemed at end-of-day NAV. ETFs generally require demat and trading accounts, whereas mutual funds may be invested in directly through fund houses or platforms.
What are the main risks associated with investing in ETFs?
Key risks include market risk, tracking error, liquidity risk in low-volume ETFs, premium or discount to NAV, and trading-related costs such as brokerage and exchange charges.
What is a tracking error in the context of an ETF?
Tracking error measures how closely an ETF tracks its benchmark. It is the standard deviation of the difference between the ETF’s returns and the benchmark’s returns over time. Expenses, cash holdings, rebalancing activity, and operational factors may contribute to variations in tracking.
Are there specific tax advantages to holding ETFs?
There are no specific tax advantages. Equity ETFs investing at least 65% in Indian equities are taxed in line with equity mutual fund rules. Short-term capital gains (applicable to units held for less than a year) are taxed at 20%, while long-term gains are taxed at 12.5% after an exemption on gains of up to Rs. 1.25 lakh Debt ETFs are treated as non-equity mutual funds and are taxed at the investor’s applicable slab rate. For commodity ETFs, such as gold ETFs or silver ETFs, STCG is taxed at 20% and LTCG is taxed at 12.5%
Are ETFs safe?
No market-linked investment is entirely risk-free. ETFs have different risk profiles depending on the asset class they track. Equity ETFs are very high risk investments linked to stock market movements, while debt ETFs are relatively stable, but remain market-linked instruments. Investors may assess risks, liquidity, and costs before investing.
