What is Exchange Traded Fund (ETF)?
An ETF (Exchange-Traded Fund) is a pooled investment vehicle, similar to a mutual fund, that holds a basket of securities such as stocks, bonds, or commodities. Unlike mutual funds, ETFs trade on stock exchanges just like individual stocks. Their portfolios typically replicate the composition of a specific benchmark index. For example, a BSE Sensex ETF will invest in the same 30 stocks that make up the BSE Sensex, mirroring its composition. Buying and selling ETFs is as easy as trading any other stock, allowing investors to take advantage of intra-day price fluctuations.
How do ETFs Work?
ETFs pool money from investors and invest that in all the stocks of the index they track, maintaining the same proportion as the index. For example, a Nifty 50 ETF will collect money from investors and invest that money in all the 50 stocks in Nifty 50 Index in the same proportion. These ETF units are then listed on stock exchanges and can be bought and sold by investors through their broking accounts, just like regular stocks.
Types of Exchange Traded Funds
Some of the popular choices of Exchange Traded Funds (ETFs) in India area as follows:
Equity ETFsEquity ETFs invest in stocks and fall into three broad categories: Market-cap-weighted ETFs (e.g., Nifty 50 Index, Nifty LargeMidcap 250 Index), Thematic ETFs (e.g., BSE Insurance and Capital Markets, Nifty Bank), and Smart Beta ETFs, which focus on factors like value, quality, low volatility, and momentum (e.g., Nifty 100 Quality 30, Nifty Midcap 150 Momentum 50).
Debt ETFsDebt ETFs invest in bonds and government securities and are classified into two types: Target Maturity Bond ETFs – These invest in bonds or G-Secs with a fixed maturity, aligning with the ETF's maturity, and are typically held until maturity. Constant Duration Bond ETFs – These invest in bonds or G-Secs maturing within a specific range, such as 1-3 years, 5 years, or 10 years.
Commodity ETFsCommodity ETFs primarily include Gold and Silver ETFs, allowing investors to gain exposure to these precious metals without physically owning them. These ETFs track the price of gold or silver and are traded on stock exchanges, providing a convenient and cost-effective way to invest in Gold and Silver.
Why invest in ETFs?
Investing in Exchange-Traded Funds (ETFs) offers several advantages, making them an attractive option for a
wide range of investors. Here are some key reasons why many choose to invest in ETFs:
Diversification ETFs offer broad exposure to multiple stocks, reducing risk by spreading investments across various securities.
Lower Costs Since they are passively managed, ETFs generally have lower expenses compared to actively managed mutual funds.
LiquidityETFs can be bought or sold throughout the day at market prices, offering real-time liquidity.
Transparency ETFs provide daily updates on holdings, allowing investors to track performance and risks easily.
Minimal/minimum Investment ETFs can be purchased in increments of a single share/unit, with no minimum investment required.
Simplicity Since ETFs track the underlying index you can just simply select an index and invest in a scheme which aims to track the same.
Risks in ETFs?
ETFs, like stocks and mutual funds, are subject to market risk, meaning their value can fluctuate based on overall market movements. While ETFs offer diversification benefits, they do not eliminate risk entirely. The level of risk depends on the breadth of the index they track—broader indices (such as Nifty 50) tend to have lower volatility compared to sector-specific or thematic ETFs.
Additionally, ETFs face tracking error and tracking difference risks:
- Tracking Error – The deviation between the ETF’s returns and the returns of the index it follows, caused by factors like fund expenses, liquidity constraints, or cash holdings.
- Tracking Difference – The difference between the actual ETF performance and the index performance over time, influenced by costs such as expense ratios and rebalancing inefficiencies.
Other risks include liquidity risk, which affects ease of buying/selling ETF units on the exchange.
How to Invest in ETF?
You can invest in ETFs (exchange traded funds) by following these simple steps:
- Open a Demat account of your choice with a broker
- Choose the ETF you wish to invest in
- Transfer funds into your brokerage account to buy the ETFs
Tax Implications on Equity and Gold/Silver ETFs?
For Equity ETFs
Long Term Capital Gains: When equity ETFs are held for a duration exceeding one year, the gains arising from them are treated as long-term capital gains and are taxed at 12.5%.
Short Term Capital Gains: When equity ETFs are held for a duration of less than one year, the gains arising from them are treated as short-term capital gains and are taxed at 20%.
For Gold/Silver ETFs
Redeemed on or after 1st April 2025 (Holding period for LTCG >12 months)
STCG taxed at their respective slab rate & LTCG is taxed at 12.5%.
Long Term Investments: ETF vs Index Funds | Learn with RG | Season 3, Episode 2
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