All You Need to Know About Exchange-Traded Funds (ETFs)

In this article, we will discuss

• What is an Exchange-Traded Fund (ETF)?
• Decoding How ETFs Work
• Different Types of Exchange-Traded Funds
• ETF Taxation in India
• Advantages of Investing in ETFs
• Limitations of Exchange-Traded Funds
• How to Invest in ETFs?
• ETFs vs Mutual Funds: The Key Differences
• Conclusion

You may be familiar with the most common types of financial instruments like equity stocks, government bonds, other government securities and even mutual funds. However, if you are interested in diversifying your investment portfolio and moving beyond online stock trading, exchange-traded funds (ETFs) may be a suitable option to consider.

In this article, we take a deep dive into what exchange-traded funds are, how they work, how you can invest in them and more. 

What is an Exchange-Traded Fund (ETF)?

An exchange-traded fund is a type of financial instrument that combines the best features of online stock trading and mutual fund investments. Like a mutual fund, an ETF also uses a pool of collective capital sourced from different investors to purchase a basket of stocks, bonds or other securities. Additionally, like stocks, ETFs can be traded on the exchange. exchange-traded funds are typically structured to track an index or a basket of securities.

Decoding How ETFs Work

Since exchange-traded funds combine the characteristics of mutual fund investments and online stock trading, they work in a slightly more complex manner than either of these two individual assets.

Shares or units in new ETFs are created and redeemed periodically by Authorised Participants (APs). The asset mix of an exchange-traded fund is designed to track and replicate a particular index or group of securities. Unlike mutual funds that aim to beat their benchmarks, ETFs simply aim to replicate or match the index they track. This makes them relatively safer investments. 

You can purchase and sell ETFs directly on stock exchanges at any time during the trading day. The prices of ETFs fluctuate on the stock exchanges based on the prevailing demand and supply. This is similar to online stock trading, where stock prices also change throughout the day as new trades are completed.

Different Types of Exchange-Traded Funds

Like mutual funds, exchange-traded funds also offer a wide range of options for investors with varying goals and levels of risk tolerance. Based on the primary investment strategy, ETFs can be classified as outlined below:

• Stock ETFs:

Also known as equity ETFs, these exchange-traded funds track a basket of equity stocks. The stocks are chosen based on the ETF’s primary strategy. So, they may be the same stocks that are present in an index, or they may be a distinct group of stocks that meet some other criteria (such as sectoral or market-cap requirements).

• Bond ETFs:

Bond ETFs invest in a mix of debt instruments like government bonds, treasury bills and other government securities. They may also invest in corporate bonds and other fixed-income instruments. These exchange-traded funds carry lower market risk than equity or stock ETFs.

• International ETFs:

These exchange-traded funds give you exposure to international markets as they invest in stocks listed on global stock exchanges. In this regard, international ETFs are similar to international mutual funds. However, they also resemble stocks because you can trade them on stock exchanges at any time during the trading day.

• Sectoral ETFs:

These are equity ETFs that choose stocks belonging to a specific sector, like healthcare or FMCG. They may either directly track a sectoral index or invest in a basket of stocks that meet specific sectoral criteria. Such ETFs are suitable for traders and investors who wish to leverage expected growth opportunities in any sector of the market.

• Thematic ETFs:

Thematic exchange-traded funds are also equity ETFs. They typically invest in stocks that fit a particular theme, like investing in developing markets or sustainable investing. You may find thematic ETFs suitable if you want to capitalise on a growing trend in the domestic or global equity markets.

• Commodity ETFs:

These exchange-traded funds make commodity investing easier for the average retail investor because they invest in commodities like crude oil, metals, cotton and other agricultural commodities. This is a more cost-effective commodity investing strategy than physically holding the commodities.

• Gold ETFs:

Gold ETFs are a special type of commodity ETFs that focus on gold investments in particular. They track the price of gold in the Indian market and passively invest in the precious metal. Typically, each unit in a gold exchange-traded fund represents one gram of gold.

• Currency ETFs:

Much like how commodity ETFs track commodity prices, currency ETFs track the currency pairs. The currency pair may include the Indian rupee and a foreign currency or may consist of two foreign currencies. If you want to gain exposure to the currency market without directly participating in forex trading, currency ETFs offer an excellent alternative.

• Passive ETFs:

Passive exchange-traded funds simply replicate and track an existing index like the Nifty 50 or the BSE Sensex. Since the index composition determines the stocks and their weightage in the ETF’s portfolio, these exchange-traded funds need not be actively constituted and managed. 

• Actively Managed ETFs:

Although ETFs are generally passive investments, some exchange-traded funds may not directly track an index. Instead, they may consist of a special basket of stocks or securities actively selected by the fund manager according to the ETF’s objective or investment strategy.

ETF Taxation in India

Exchange-traded funds may offer two types of income, namely, dividends and capital gains. Dividends from ETFs are added to your total income and taxed at the income tax slab rate applicable.

Capital gains, on the other hand, need to first be classified as long-term or short-term gains before the relevant income tax rate is applied. This classification depends on these factors:

• The type of ETFs
• The holding period of the ETFs

Here is a summary of how capital gains from different types of ETFs with different holding periods are taxed.

Note: These rates are w.e.f. April 1, 2023

Advantages of Investing in ETFs

Trading or investing in ETFs gives you the following advantages:

• Liquidity and Flexibility: ETFs can be bought and sold like stocks throughout the trading day. This makes them highly liquid and flexible investments.

• Lower Expense Ratios: Generally, ETFs have lower expense ratios than mutual funds. This makes them a cost-effective investment option.

• Easy Diversification: ETFs often track indexes or sectors that provide instant diversification across a wide range of assets — all with a single investment.

• Transparency: ETFs are required to disclose their holdings daily. This allows you to know exactly what assets you are investing in.

• Accessibility: ETFs usually do not have a minimum investment requirement, so they are accessible to all investors.

Limitations of Exchange-Traded Funds

Exchange-traded funds also have some downsides and limitations, as outlined below:

• Lack of Control: If you choose to invest in an exchange-traded fund, you may not have significant control over the assets chosen for your portfolio.

• Tracking Error: ETFs may not replicate the performance of their underlying index perfectly due to tracking errors that may stem from management fees and other factors.

• Trading Costs: Although ETFs have lower expense ratios than other options, these costs can add up for frequent traders.

How to Invest in ETFs?

If you want to leverage the benefits of exchange-traded funds, here is how you can get started with your ETF investments.

• Step 1: Open a Demat Account

Choose a reputable online brokerage partner like Samco Securities and complete the demat account opening process.

• Step 2: Fund Your Account

Transfer money from your bank account to your brokerage account. This can usually be done via different modes like UPI, internet banking etc.

• Step 3: Choose ETFs

Compare different ETFs and choose the funds that best align with your goals, risk tolerance and investment requirements.

• Step 4: Place Your Order

Log into your brokerage account, choose the type of order (market order, limit order, etc.), enter the number of units you wish to purchase and place your order.

ETFs vs Mutual Funds: The Key Differences

Since exchange-traded funds are very similar to mutual funds, many investors find themselves confused between the two asset variants. The table below summarises the key differences between ETFs and mutual funds, so you can make well-informed investment choices.

Conclusion

The bottom line is that ETFs give you exposure to various asset classes like equity stocks, government bonds, other government securities, commodities, currencies and more. By choosing to invest or trade in ETFs, you can get the benefits of various other strategies combined, like commodity investing, online stock trading and mutual fund investing.

To trade in ETFs or invest in them, you need to have a demat account with a registered broker. The Samco demat account may be just what you need to get started on your ETF trading or investing journey today.

Disclaimer: INVESTMENT IN SECURITIES MARKET ARE SUBJECT TO MARKET RISKS, READ ALL THE RELATED DOCUMENTS CAREFULLY BEFORE INVESTING. The asset classes and securities quoted in the film are exemplary and are not recommendatory. SAMCO Securities Limited (Formerly known as Samruddhi Stock Brokers Limited): BSE: 935 | NSE: 12135 | MSEI- 31600 | SEBI Reg. No.: INZ000002535 | AMFI Reg. No. 120121 | Depository Participant: CDSL: IN-DP-CDSL-443-2008 CIN No.: U67120MH2004PLC146183 | SAMCO Commodities Limited (Formerly known as Samruddhi Tradecom India Limited) | MCX- 55190 | SEBI Reg. No.: INZ000013932 Registered Address: Samco Securities Limited, 1004 - A, 10th Floor, Naman Midtown - A Wing, Senapati Bapat Marg, Prabhadevi, Mumbai - 400 013, Maharashtra, India. For any complaints Email - grievances@samco.in Research Analysts -SEBI Reg.No.-INHO0O0005847