Exchange Traded Funds – Definition, Types, and Benefits

Apart from mutual funds, ETF investments are also on the rise. They are some of the most popular investment options lately. ETFs have gained quite a level of popularity in the marketplace with their simple, cost-efficient, and flexible nature. They are perfect investments for novices as well as pros and have diversified exposures to various classes of assets.

Overview of ETFs

Let’s answer the question of what Exchange-Traded Funds are, but before that, let’s get a basic understanding of the concept!

ETFs are investment products that reflect the characteristics of mutual funds and stocks. They are traded on the stock exchange, just like any other individual stocks, and they tend to follow an index, sector, commodity, or class of assets. This makes them an easy choice for an investor who wants to obtain a diversified portfolio without dealing with individual investments.

What Are ETFs?

Let’s get started on understanding what ETF investment is!

An ETF is an investment vehicle consisting of a pool of underlying assets, such as stocks, bonds, or commodities. Each unit represents a proportionate share of the fund’s holdings. Investors buy and sell units on stock exchanges during market hours, making ETFs highly liquid and accessible.

How ETFs Work: A Step-by-Step Explanation

ETFs work on a creation and redemption mechanism as follows:

• Creation: The Authorized Participants (APs) create ETF units by exchanging underlying assets with the fund.
• Trading: Investors buy and sell ETF units on the stock exchange.
• Redemption: The APs redeem ETF units by returning the units to the fund against the underlying assets.

The above structure ensures that ETFs closely track their benchmark index and provide liquidity to the investors.

Discover the Variety of ETFs

ETFs are available in many variations to fit a specific investment requirement.

1. Equity ETF: These mimic stock indexes like the S&P 500 or Nifty 50.
2. Bond ETF: Generally replicating fixed-income security or government and corporate bonds.
3. Commodity ETFs: These have similar profiles to direct investments in physical commodities, such as gold or silver.
4. Sector ETF: These funds are invested in a given sector, like technology, healthcare, etc.
5. Thematic ETFs: Themes to Track: Green energy or artificial intelligence.
6. International ETFs: These can provide exposure to global markets or to any specific country.

Advantages of Investing in ETFs

Diversification: ETFs offer an investor access to a wide variety of assets, thereby reducing risk.

Diversification: Access to varied assets reduces risk.

• Low Costs: ETFs have lower expense ratios when compared to actively managed funds.
• Liquidity: They could be purchased and sold on exchanges during trading.
• Transparency: Holdings of ETFs are disclosed often and, therefore, transparent.
• Flexibility: Suits various strategies, from passive to thematic.

Disadvantages of ETFs

Although there are various benefits to holding ETFs, they aren’t risk-free:

• Market Risk: Prices fluctuate with the market.
• Tracking Error: Some ETFs need to track the benchmark more perfectly.
• Liquidity Risk: Some niche ETFs have lower trading volumes, leading to less liquidity.
• Counterparty Risk: The synthetic ETF carries a counterparty risk of the counterpart’s default while providing returns.

How to Invest in ETFs: A Step-by-Step Guide

Investing in ETFs is as simple as investing in mutual funds, just follow the steps mentioned below to get started:

• Choose an ETF: Select one from among the many existing ETFs in the market. Selection depends on the purpose of investment as well as your risk profile.
• Open a Demat Account: ETFs are bought through a Demat and trading account.
• Order Placement: You can buy units of an ETF from a stock exchange through your trading account.
• Performance Tracking: Keep tracking the performance of the ETF relative to its benchmark.

Taxation on ETFs in India

Below is a detailed table and explanation of the tax implications for different types of ETFs in India:

Type of ETF	Short-Term Capital Gains (STCG)	Long-Term Capital Gains (LTCG)
Equity ETFs	20%	12.5% (without indexation)
Gold ETFs	Taxed as per income tax slab rate	12.5% (without indexation)
Debt ETFs	Taxed as per income tax slab rate	Taxed as per income tax slab rate
Other Non-Equity ETFs	Taxed as per income tax slab rate	12.5% (without indexation)

Short-Term Capital Gains (STCG):

• STCG from stocks, equity funds, and units of business trusts (like InvITs and REITs) is taxed at 20%.
• For other asset classes, STCG is taxed based on the investor’s income tax slab.

Long-Term Capital Gains (LTCG):

• LTCG for all asset classes is uniformly taxed at 12.5% without indexation benefits, effective July 23, 2024.
• Earlier, LTCG was taxed at 20% with indexation and 10% without indexation.

Debt Funds and ETFs:

• Profits from debt mutual funds and ETFs are taxed based on the investor’s income tax slab, irrespective of the holding period.

Tax on ETF Dividends

Dividend income, previously subject to a 15% Dividend Distribution Tax (DDT) until FY 2020-21, is now added to the investor’s total annual income and taxed according to their income tax slab.

Tax on ETF Capital Gains

For Equity ETFs:

• Short-Term Capital Gains (STCG):
  • Gains from shares held for less than a year are taxed at 20% under Section 111A.
• Long-Term Capital Gains (LTCG):
  • Gains from shares held for more than a year are taxed at 12.5% without indexation benefits, as per the 2024 budget.

For Gold, Debt, and Other ETFs:

• Short-Term Capital Gains (STCG):
  • Gains from assets sold within three years are added to the investor’s annual income and taxed as per their slab rate.
• Long-Term Capital Gains (LTCG):
  • Gains from assets held for more than three years are taxed at 12.5% without indexation benefits.

Holding Period for Mutual Funds

• Equity Mutual Funds:
  • Short-term: Held for 12 months or less.
  • Long-term: Held for more than 12 months.
• Other Mutual Funds:
  • Short-term: Held for 24 months or less.
  • Long-term: Held for more than 24 months.

Comparing ETFs, Stocks, and Mutual Funds: What Sets Them Apart?

Here’s a table of comparison between ETFs, stocks, and mutual funds to understand what would be the best choice for you:

Feature	ETFs	Stocks	Mutual Funds
Trading	Throughout the day	Throughout the day	End of the day NAV
Diversification	High	Low	High
Costs	Low	Varies	Higher than ETFs
Management	Passive (usually)	N/A	Active or Passive

ETFs strike a balance between the simplicity of stocks and the diversification of mutual funds, making them a versatile option.

Conclusion

ETFs are a strong investment tool, providing flexibility, cost efficiency, and diversification that are hard to find in any investment. They are a tool for beginners as well as seasoned investors who can achieve their goals while minimizing risks. However, investors must research thoroughly and be aware of associated risks to align with financial goals and get ahead of the market.

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