Exchange-Traded Funds

ETFs, or Exchange-Traded Funds, are diversified investment avenues that trade on stock exchanges like individual stocks. Similar to mutual funds, ETF investments offer diversification by holding a variety of stocks, bonds, or commodities.
However, unlike mutual funds, ETFs can be bought and sold throughout the trading day at the price quoted on exchange, which is based on the current value of their underlying securities.
Moreover, with most mutual funds, a manager actively chooses the portfolio holdings and makes buy or sell decisions based on the investment strategy and objectives. The goal is usually to outperform the broader market. In comparison, ETFs mirror an existing stock market index (such as the Nifty 50) and seek to replicate its performance (subject to a tracking error, which is the difference between the fund’s performance and that of its benchmark).

An ETF investment comprises a basket of securities. This could include stocks, bonds, commodities etc. The exact composition of the ETF portfolio depends on the index it is tracking. For example, a Nifty 50 ETF will be made of stocks of the country’s top 50 companies on the National Stock Exchange. The portfolio composition will mirror the benchmark index (in this case, the Nifty 50).
This is similar to how index mutual funds work. However, unlike mutual funds, which can only be bought and sold at the day’s end, based on the Net Asset Value (NAV), ETFs trade throughout the day on stock exchanges, just like individual stocks. The mutual fund’s NAV depends on the closing prices of its underlying securities (among other factors). An ETF can trade at a premium or discount to the NAV, based on the value of the portfolio’s holding at the time that units are being bought or sold. Therefore, ETF investments provide intra-day liquidity and opportunities to implement trading strategies.

Investors should keep the following factors in mind when investing in ETFs:

Benchmark index: The index on which the ETF is based will influence the risk-reward balance of the fund. Conservative investors may not find equity ETF suitable. Alternatively, investors comfortable with equity investments may want to consider whether they want options with relatively lower volatility (such as large cap ETFs) or higher-risk options with higher reward potential (such as mid or small cap ETFs). Investors with existing mutual fund investments in debt or equity may want to diversify through a commodity ETF. The ETF type will need to align with the investor’s risk appetite and financial goal.
Investment objective: Consider what your objectives are when investing in ETFs. If growth potential is your goal, some actively managed mutual funds may offer the potential for market-beating returns. However, if you prefer a passive investment strategy that seeks to replicate market movements, you may consider ETF investments or index funds. You may also prefer ETFs if you want intra-day liquidity and trading options.
Investment horizon: Consider your timeline when investing in ETFs. Short-term goals might require relatively stable ETFs that invest in fixed-income securities, while long-term goals can accommodate more volatile options.
Market conditions: Consider the current market environment and how the ETF might perform under different economic conditions.
Tracking error: When investing in ETFs, it is also crucial to check the fund’s tracking error, which measures how closely the ETF follows its benchmark index. The lower the tracking error, the closer an ETFs performance is to its benchmark.

There are numerous types of ETF funds in India. Depending on the benchmark index, an ETF may invest in stocks or bonds. There are also gold ETFs, which reflect the prices of domestic gold in India. Within stocks, it may invest in large, mid or small cap companies. Some ETF investments may track certain sectors while others may track indices whose stocks are chosen based on certain factors (such as value or momentum stocks). Some ETF types are:

Broad-market ETFs: These are passively managed funds that track a specific broad-market stock market index, such as the Nifty 50 or BSE Sensex. They aim to replicate the performance of the index by holding the stocks in same proportion as the index, subject to tracking error.
Gold ETFs: These funds track the market performance of gold. They provide a convenient way to invest in gold without the need to physically hold the metal. The prices of gold ETFs fluctuate with the market prices of the commodity.
Bond ETFs: Bond ETFs invest in a portfolio of bonds and seek to potentially provide regular income along with relative stability. These can include government or corporate bonds.
Sector ETFs: These funds invest in specific sectors of the economy, such as banking, technology, or pharmaceuticals. They replicate the benchmark index of the sector.
Others: Some ETFs are based on indices that follow a certain investment strategy focusing on value, momentum or low-,volatility stocks among other factors. Examples include Nifty 200 Momentum 30 ETF and Nifty50 Value 20, among others.

Choosing between ETFs, mutual funds and stocks can feel confusing because all three help you invest in the market, but they work in different ways. Here is a simple comparison that explains how they differ across key factors to help you understand which option may suit different investing needs:

Like with any investment, there are certain risks that you should be aware of when investing in ETFs:
Tracking error: The performance of an ETF investment can deviate from its benchmark index. This is called tracking errors. A low tracking error indicates that ETF is closely matched with its benchmark index.
Market risk: Like any investment, ETFs are subject to market fluctuations. The value of your ETF can decline if the underlying securities perform poorly.
Liquidity risk: While generally liquid, some ETFs might have lower trading volume, making it harder to buy or sell units quickly at a desired price. Moreover, certain market conditions may also temporarily affect liquidity.

ETFs can be a convenient way to invest in a basket of securities through a single market-traded instrument. However, before investing, it is useful to understand both the benefits and the limitations.

Advantages of ETFs

Here is a closer look at the advantages of ETFs and how they may support different investment goals:

Lower costs

ETFs are usually passively managed and often track an index. As a result, they typically have lower expense ratios than many actively managed mutual funds.

Intraday trading

ETFs can be bought and sold on stock exchanges during market hours, just like shares. This gives investors the flexibility to trade at live market prices.

Diversification

A single ETF can offer exposure to multiple securities, sectors or asset classes. This can help reduce the risk of depending on one individual stock.

Transparency

Many ETFs disclose their holdings regularly. This helps investors understand where their money is invested.

Easy accessibility

ETFs can often be purchased for the price of a single unit, subject to the prevailing market price. Investors can often start with the price of one ETF unit.

Wide range of options

ETFs are available across indices, sectors, themes and asset classes. This allows investors to choose options based on their financial goals and risk appetite.

Disadvantages of ETFs

Here are some of the key risks and limitations of ETFs that are worth considering alongside their benefits:

Tracking error

An ETF may not exactly match the return of the index it follows. This difference is called tracking error and can happen due to costs, cash holdings or market factors.

Liquidity risk

Some ETFs may have low trading volumes. This can make it difficult to buy or sell units quickly at the desired price.

Bid-ask spread

The buying price and selling price of an ETF may differ. In less-traded ETFs, this difference can become an additional cost for investors.

Brokerage and transaction costs

ETFs are bought and sold on stock exchanges, just like shares. As a result, brokerage and other transaction charges may apply when you trade them.

Over-trading risk

Because ETFs can be traded throughout the day, investors may be tempted to buy and sell more frequently. This can increase costs and may lead to short-term, emotional decisions.

Market risk

ETF values generally move in line with the performance of their underlying securities. If the market or index falls, the ETF value may also decline.

Here are some of the benefits of investing in ETFs:
Diversification: ETFs provide exposure to a broad range of assets, helping reduce individual stock or sector risk.
Low costs: ETFs generally have lower fees than actively managed funds, keeping more of your returns.
Flexibility: You can buy and sell ETFs anytime during market hours, just like stocks.

ETF taxation in India depends on the type of ETF, what it invests in and how long you hold it. Here is a simple overview:

ETFs may declare dividends, and whether you receive them as a payout or reinvest them, the amount is added to your income and taxed as per your applicable income tax slab. TDS is generally deducted at 10% if total dividend income exceeds ₹10,000 in a financial year, and this income is usually reported under Income from other sources in the ITR. For international ETFs, resident investors may need additional foreign income and asset reporting.

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.

ETF investments can be suitable for a diverse range of investors. This can include:

1) New investors who seek exposure to various assets through a single investment.
2) Seasoned investors seeking portfolio diversification or the inclusion of specific asset classes.
3) Investors who want to reduce the role of a fund manager’s decision-making on their investment and prefer to align it with broader market movements.
4) Investors seeking intra-day liquidity and trading flexibility.
5) Investors who want lower expense ratios than that charged by active mutual funds,

To invest in ETFs in India, start by opening a Demat and trading account. Once set up, choose an ETF that aligns with your financial goals. Before investing, review key factors like past performance, expense ratio, and tracking error. ETFs are traded like stocks, so you can buy and sell them directly through your trading platform during market hours.