In recent years, mutual funds have seen increased participation from retail investors in India. Many investors’ mutual funds – which are professionally managed and diversified by nature – are easier to manage and more accessible than trading individual stocks.
However, some investors may not be aware that they can access certain features associated with both mutual funds and listed stocks through Exchange-Traded Funds (ETFs). ETFs allow investors to gain exposure to a basket of securities through a single instrument, while also enabling trading on stock exchanges similar to shares. Investors may buy or sell ETF units through their demat and trading accounts during market hours.
Broadly, ETFs in India may include equity ETFs (including index and sector ETFs), debt ETFs, and commodity ETFs, with some specialised structures also emerging in the market.
Table of Contents:
- Types of ETFs in India
- Taxation of gains from ETF units
Types of ETFs in India
ETFs in India are generally index-linked. These ETFs aim to replicate the performance of a specific market index such as the Nifty 50, Nifty Next 50, or BSE Sensex. An index ETF generally holds securities in proportions similar to the underlying index. If the ETF tracks a mid-cap index, the portfolio will typically include the same companies that are part of that index in similar weightages. The portfolio composition usually changes only when the underlying index undergoes periodic rebalancing. Because of the passive investment approach, index ETFs may have relatively lower expense ratios compared to actively managed equity funds.
With regard to the types of assets they invest in, ETFs can be categorised as follows:
Equity ETFs
An equity ETF invests primarily in shares of listed companies. These ETFs typically aim to replicate the performance of a specific market index such as the Nifty 50 or BSE Sensex. By purchasing a unit of a Nifty 50 ETF, investors receive proportionate exposure to the companies that form part of that index. Units of equity ETFs can be bought or sold on the stock exchange during trading hours.
Equity ETFs usually follow a passive investment strategy, where the portfolio mirrors the composition of the underlying index rather than the fund manager selecting securities actively. Because of this passive approach, equity ETFs generally have relatively lower expense ratios compared to actively managed equity mutual funds.
Debt ETFs
Debt ETFs primarily invest in fixed income instruments such as government securities, treasury bills, state development loans (SDLs), and corporate or public sector undertaking (PSU) bonds. These instruments typically generate potential returns through interest income and price movements in the bond market.
The objective of debt ETFs is generally to provide exposure to fixed income securities that may exhibit relatively lower volatility compared to equity instruments. Some debt ETFs invest significantly in government securities, which may carry relatively lower default risk compared to corporate issuances. However, debt ETFs remain exposed to interest rate risk and market fluctuations, and returns are not guaranteed.
Commodity ETFs
Commodity ETFs track the price movements of specific commodities. In India, these ETFs commonly track commodities such as gold or silver.
Many investors traditionally hold physical commodities such as gold as a potential hedge against inflation. However, physical ownership may involve making charges, storage costs, and security considerations. Commodity ETFs provide exposure to the price movement of the underlying commodity without requiring investors to hold it physically. The ETF units are held in demat form and traded on stock exchanges.
Liquid ETFs
Liquid ETFs invest in very short duration money market instruments such as treasury bills, certificates of deposit, commercial papers, and repo or reverse repo instruments.
These ETFs are designed to reflect returns from short-duration instruments in the money market. Investors may buy or sell units during market hours through the stock exchange. Compared to equity ETFs, price volatility in liquid ETFs is generally lower because of the short maturity profile of the underlying instruments. However, investors should note that these funds are still subject to market and liquidity risks.
Sector ETFs
Sector ETFs provide exposure to a specific sector of the economy such as banking, pharmaceuticals, or information technology. Instead of investing across the entire market, these ETFs concentrate on companies operating within a particular industry.
While this structure provides diversification within the selected sector, the overall portfolio remains exposed to sector-specific risks. If the sector experiences regulatory changes, economic pressures, or cyclical downturns, the ETF’s value may be affected accordingly. Because of this concentration, sector ETFs may exhibit higher volatility compared to diversified market index ETFs.
Active ETFs
ETFs are typically structured as passive investment vehicles that track an index. However, in some global markets, actively managed ETFs have been introduced. In such ETFs, the fund manager selects securities based on an investment strategy rather than strictly replicating an index.
Actively managed ETFs may have higher expense ratios compared to passive ETFs because of the active portfolio management involved. Active ETFs are currently not available in India.
Also Read: How To Invest In ETFs In India? Beginners Guide
Taxation of gains from ETF units
- Equity ETFs: If an equity ETF has at least 65% exposure to equity and equity related instruments, it is treated as an equity-oriented fund for taxation purposes. If the units are sold within 12 months of purchase, the gains are classified as short-term capital gains and taxed at 20%. If the units are held for more than 12 months, the gains are classified as long-term capital gains and taxed at 12.5% on the portion of gains exceeding ₹1.25 lakh in a financial year.
- Debt ETFs: Debt ETFs and other ETFs with less than 65% exposure to equity are treated as non-equity funds for taxation purposes. Capital gains from such ETFs are added to the investor’s income and taxed according to the applicable income tax slab rate. Indexation benefits are not available for investments made after April 1, 2023.
- Gold and silver ETFs: Gold and silver ETFs are generally treated as non-equity ETFs for taxation purposes. If the units are sold within 12 months of purchase, the gains are typically classified as short-term capital gains and taxed according to the investors applicable tax slabs. If the units are held for more than 12 months, the gains are generally classified as long-term capital gains and taxed at 12.5% without indexation.
The ₹1.25 lakhs annual exemption applicable to long-term capital gains on equity-oriented funds does not apply to gold and silver ETFs.
Conclusion
The range of ETFs available in India has expanded over the years. Investors today can access ETFs that provide exposure to broad market indices, specific sectors, fixed income instruments, or commodities through a single investment vehicle. Since each ETF category carries its own risk characteristics, investors may consider their financial goals, risk appetite, and investment horizon before investing. It is also important to understand how the ETF is structured and the assets it tracks. Factors such as tracking error, liquidity of ETF units, trading volumes, and bid-ask spreads may influence the trading experience of investors in ETFs.
FAQs
What are the main types of ETFs available for investors?
Common categories of ETFs in India include equity ETFs, debt ETFs, commodity ETFs, liquid ETFs, and sector ETFs. Each category provides exposure to a different asset class or segment of the market and may involve different levels of risk.
How are equity ETFs different from debt ETFs?
Equity ETFs invest primarily in shares of listed companies and are exposed to equity market movements. Debt ETFs invest in fixed income instruments such as government securities or corporate bonds. Because of their underlying assets, equity ETFs typically involve higher volatility than debt ETFs.
What is an index ETF and how does it work?
An index ETF aims to replicate the performance of a specific market index. It invests in the same companies that form part of the index, generally in similar weightages. Units of index ETFs are traded on stock exchanges during market hours similar to listed shares.
What are commodity ETFs and what assets do they invest in?
Commodity ETFs track the price movements of commodities such as gold or silver. They allow investors to gain exposure to these commodities through demat holdings without purchasing or storing the physical asset.
How do ETFs help in portfolio diversification?
An ETF provides exposure to multiple securities through a single unit. Because the investment is spread across several holdings within the ETF portfolio, the impact of the underperformance of an individual security may potentially be moderated by other securities in the portfolio.
