Are Exchange Traded Funds The Right Investment For You?

Exchange Traded Funds (ETFs) have emerged as a popular investment option in India, providing investors with a convenient and cost-effective way to gain exposure to a diversified portfolio of securities. These funds have achieved significant traction due to their unique characteristics and potential benefits. Vardan Pandhare explores the world of ETFs as an investment avenue

Exchange Traded Funds (ETFs) are a type of investment fund that are traded on a stock exchange. They are similar to mutual funds, but they have some key differences. ETFs are passively managed, which means that they track a specific market index such as the Nifty or the Sensex. This implies that they are less expensive than mutual funds, which are actively managed. ETFs can also be traded throughout the day, just like stocks. In 2022, the total assets under management (AUM) of ETFs in India were over Rs 1 trillion. This is a significant increase from the AUM of Rs 200 billion in 2015.[EasyDNNnews:PaidContentStart]
 

There are several reasons for the growing popularity of ETFs in India. One reason is that ETFs offer a number of benefits such as low fees, liquidity and diversification. Another reason is that ETFs are becoming more accessible to investors. In the past, ETFs were available only to institutional investors. However, now they are available to retail investors through online brokerage platforms. As the popularity of ETFs continues to grow in India, there are a number of trends that we can expect to see. One is that we will see more ETFs being launched. Another trend is that we will see more investors using ETFs to diversify their portfolios.
 

Passive Management

Passive management lies at the core of ETFs, distinguishing them from actively managed funds. The primary objective of an ETF is to replicate the performance of a specific market index, which gives rise to a style of fund management known as passive management. This approach offers several advantages for investors in index funds. In passive management, the role of the fund manager is to make only minor adjustments periodically to ensure the ETF remains in line with its target index. 

Unlike actively managed funds, where fund managers make active investment decisions in an attempt to outperform the market, ETF investors do not seek the expertise of fund managers to actively manage their investments. Instead, they aim to achieve returns that closely mirror those of the benchmark index. ETFs typically focus on a specific index and hold a discrete number of stocks, providing a more defined investment scope compared to the constantly changing investment options of mutual funds.

This characteristic helps mitigate the risks associated with fund managers’ decision-making – making the selection process less complicated for investors. By investing in ETFs, individuals tap into the collective performance of the market itself rather than relying on the active management strategies of fund managers. In summary, passive management is a fundamental feature of ETFs, allowing investors to passively replicate the performance of a market index. This approach provides simplicity, transparency and the potential to achieve returns in line with the chosen benchmark index.

Working of ETFs

As mentioned above, ETFs function as a unique type of mutual fund that is traded on the stock exchange, offering investors the ability to buy and sell them just like individual stocks. While most ETFs follow a passive management approach, it’s worth noting that there are also actively managed ETFs available. Passive ETFs are designed to track various indices, such as the Nifty 50, which invests in the constituent companies of the index in proportion to their weights in the index. These ETFs can also track sector-specific indices like Nifty Pharma or commodities such as gold which mirror the price movements of physical gold. Similar to other mutual funds, ETFs are initially offered as New Fund Offers (NFOs) by fund houses. However, after the NFO period, the units of ETFs are listed on a stock exchange. 

Investors can then purchase or sell these units on the exchange during regular market hours similar to trading individual stocks. Additionally, ETFs are assigned specific symbols, similar to the ticker symbols used to identify individual company shares. For instance, a renowned IT company like Infosys is listed on the exchange with the symbol ‘RIL’ and investors can search for the share price of Reliance Industries Limited by looking for RIL. Likewise, each ETF is allocated a unique ticker symbol as an identifier, allowing investors to identify and track the ETF’s current price.

Understanding the Terms

Before venturing into ETFs, investors must familiarise themselves with important terms like NAV, market price and tracking error.

1. Net Asset Value (NAV) and Market Price: As ETFs encompass elements of both mutual funds and stocks, it is essential to grasp the concepts of NAV and market price. The NAV represents the underlying asset value of an ETF, while the market price refers to the price at which the ETF units are bought and sold on the exchange. Typically, a slight discrepancy may exist between the market price and NAV of an ETF, influenced by supply and demand dynamics. Since investors transact ETFs through the exchange, their returns are contingent to the market price at the time of buying or selling, rather than the NAV

2. Tracking Error: Tracking error pertains to the variance in performance between an ETF and the index it aims to replicate. Several factors contribute to tracking error, including delays in security transactions, scheme expenses and the presence of cash or cash equivalents within the ETF’s holdings. Consequently, ETFs cannot perfectly mirror the returns of their target index. In practical terms, a higher tracking error indicates a greater deviation in the fund’s performance from its intended index. Therefore, it is advisable to monitor and select ETFs with lower tracking error to align investment objectives.

Types of ETFs

In India, various types of ETFs are available, each serving different investment objectives. Here are the key categories:

■ Gold ETFs — These offer investors exposure to the bullion market without the need to physically own gold. These ETFs typically rise in value when gold prices increase and vice versa.

■ Equity ETFs — These are passively managed funds that replicate stock indices. They invest in a diverse range of securities, mirroring the composition and performance of the underlying index. These ETFs provide transparency and generally have lower expense ratios compared to mutual funds.

■ Debt ETFs —These are passively managed funds that invest in fixed income securities according to their underlying index. They offer benefits such as liquidity, transparency and cost efficiency. While initially popular among institutional investors, debt ETFs are gaining traction among retail investors.

■ Currency ETFs — These ETFs enable investors to participate in currency markets without directly investing in a specific currency. These ETFs aim to benefit from price fluctuations relative to individual or multiple currencies.



■ Low Fees — ETFs are typically very low-cost investments. This is because they are passively managed, which means that there is no need to pay active management fees. n Liquidity — ETFs can be traded throughout the day, just like stocks. This means that you can easily buy and sell ETFs whenever you want.

■ Diversification — ETFs can help you to diversify your investment portfolio. This is because they track the performance of a specific market index, which means that you are investing in a wide range of stocks or bonds.

■ Transparency — ETFs are very transparent investments. You can easily see the underlying assets that an ETF is tracking, as well as the fees that are associated with the ETF.


■ Bond ETFs — These provide exposure to government and corporate bonds. They are suitable for investors seeking diversification and risk mitigation within their portfolios.

■ Commodity ETFs — These invest in agricultural or non-agricultural commodities or commodity futures. They often track indices representing specific commodities like precious metals, agricultural products or natural resources. Commodity ETFs contribute to portfolio diversification and can act as a hedge against inflation.

■ International ETFs — These focus on foreign-based securities and can invest in equities or fixed income securities. They may target specific regions or countries, tracking country-specific benchmark indices or global markets. Investors should assess their risk profile before investing in international ETFs.

■ Sectoral or Thematic ETFs — Sectoral ETFs concentrate on specific sectors while thematic ETFs focus on trends or themes. Sectoral ETFs may target industries like energy while thematic ETFs revolve around themes such as renewable energy.

■ Index Fund ETFs — These allow investors to gain exposure to a collection of securities in one investment. They aim to replicate the performance of specific stock market indices such as the Sensex or Nifty 50.

■ Liquid ETFs — These allocate funds to low-maturity government securities, such as overnight funds, to minimise price fluctuations while ensuring high liquidity for investors.

By understanding the different types of ETFs available, investors can align their investment goals and risk preferences with the appropriate ETF categories.

Popular Categories of ETFs and Symbols

Equity index ETFs are investment funds that derive their unit price from a portfolio of capital market securities. The specific securities within the portfolio vary depending on the nature of the ETF. For instance, ETFs like NIFTYBeEs or UTISUNDER derive their value from securities that constitute the Nifty index. Equity index ETFs are ideal for building long-term core equity holding by systematically investing in various index funds such as Nifty ETFs, Nifty Junior ETFs, Nifty Sharia ETFs, Bank ETFs, and more. Investors seeking exposure to the overall market without individual stock selection may opt for an index ETF if they have a bullish market outlook.

Gold ETF

These are investment units that represent physical gold, available on paper or dematerialised form. Similar to individual stocks of companies, these units are traded on the exchange. Gold ETFs allow investors to include gold as a component of their portfolio, accumulate gold for social responsibilities, or use the units to purchase jewellery or other physical forms of gold when desired.

Difference Between ETFs and Index Funds

Investors often find themselves perplexed when it comes to differentiating between ETFs and index funds. While both types of funds aim to replicate specific indices, there exist distinctive features that set them apart. Let’s explore these differences in the following comparison table.

The ETF market in India is expected to continue to grow in the coming years. According to a report by Motilal Oswal, the AUM in ETFs in India could reach Rs 10 trillion by 2025. This growth will be driven by several factors, including:

■ Increased participation from retail investors. Retail investors are becoming more interested in ETFs as they become more aware of the benefits of these products.

■ Launch of new ETFs. A number of new ETFs are expected to be launched in the coming years, giving investors more options to choose from.

■ Rise of passive investing. Passive investing is becoming increasingly popular in India and ETFs are an attractive option to implement a passive investment strategy 

Taxation of ETFs

ETFs are subject to specific tax rules based on their classification and holding period. The tax treatment of ETFs can vary depending on the type of ETF. Let’s examine the tax implications for different categories of ETFs.

Distinguishing Features of ETFs and MFs

One key differentiation between ETFs and mutual funds (MFs) lies in their accessibility and trading characteristics. ETFs can be bought and sold on exchanges, similar to regular shares, while MF units can only be purchased from fund houses. 
ETFs offer flexibility as there is typically no minimum lock-in period. Investors can buy and sell ETF shares at their convenience without incurring penalties. On the other hand, MF units often involve a minimum lock-in period, and selling them before this duration may result in penalties. 
In terms of management, MFs are actively managed by professional fund managers. ETFs, however, are passive investment options that track the performance of an index or a broader set of instruments.
When it comes to investment requirements, both MFs and ETFs offer entry with a small sum of money, making them accessible to a wide range of investors. 

Index ETFs and Sectoral ETFs (Equity-Oriented Schemes)

■ Short-Term Capital Gains: If ETF units are held for less than one year, any gains are taxed at a rate of 15 per cent.
■ Long-Term Capital Gains: If ETF units are held for more than one year, gains exceeding Rs 1 lakh are taxed at 10 per cent without the benefit of indexation. However, long-term gains up to Rs 1 lakh are exempt from tax.

Gold ETFs and International ETFs (Non-Equity Funds)

■ Short-Term Gains: If ETF units are held for less than 36 months, short-term gains are taxed at the individual’s applicable Income Tax slab rate.
■ Long-Term Capital Gains: If ETF units are held for more than one year, gains are taxed at a flat rate of 20 per cent after considering indexation benefits.

Risks Involved in ETF Investment

■ Limited Liquidity: When it comes to non-ETFs, if you require your funds you can sell the units back to the fund house and have the amount credited to your bank account. However, with ETFs, the units are traded on an exchange, which means there must be interested buyers for your units. In the case of thinly traded Exchange Traded Funds, there may be concerns regarding liquidity. Imagine a scenario where there are no buyers for your ETF units. In such situations, you might face difficulties in selling your units or be forced to sell them at a lower price.
■ No Outperformance: ETFs are designed to track an index, making it unlikely for them to outperform the index. Unlike actively managed funds, the expectation for returns from an ETF should not revolve around outperforming its underlying index.

Consider this before investing in ETFs:

■ It is crucial to have a well-defined investment strategy when considering ETF investments. Currently, ETFs tend to focus primarily on Large-Cap securities.
■ When selecting ETFs, two essential factors to consider are the expense ratio and tracking errors. Opt for ETFs with low expense ratios and minimal deviation from the market benchmark returns.
■ Since ETFs are traded exclusively on stock exchanges, liquidity becomes a significant factor to evaluate when making ETF investments. While some ETFs, such as Sensex and Nifty ETFs, have high trading volumes, not all ETFs exhibit the same level of liquidity.
■ Investing in ETFs requires you to have demat and trading accounts. Although there are associated costs with these accounts, they are generally lower compared to the expense ratio advantage offered by ETFs.

Conclusion
As the efficiency of the markets, such as the Dow Jones or Nasdaq in the US, increases, generating alpha becomes progressively challenging. In India, over time, the performance gap between actively managed schemes and ETFs will diminish with cost playing a crucial role in determining returns. ETFs offer an excellent option for low-cost investments and their popularity is expected to grow. While the best-performing actively managed mutual funds can outperform ETFs in the long run, it is important to note that many actively managed schemes also underperform compared to ETFs. In our opinion, it is advisable to have a combination of actively managed schemes and ETFs in your investment portfolio. The allocation percentages for each category should be based on your risk appetite, and it is recommended to consult a financial advisor. When it comes to investing in gold, gold ETFs provide a more efficient and secure alternative compared to physical assets.

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