Learn about Exchange-Traded
Funds (ETFs)

An ETF, short for Exchange Traded Fund, is a financial instrument that mirrors the performance of an equity or debt market index, an international index or specific commodity (e.g. Gold, Silver etc) and is traded on a stock exchange. You need demat and trading accounts to invest in ETFs. Essentially, when you invest in an ETF, such as the Nifty 50 ETF or BSE Sensex ETF, you’re investing in a basket of stocks that reflects the selected index. Unlike traditional mutual funds, ETFs don’t aim to beat their referenced index returns; they aim to match it. As such, rather than competing against the market, they mirror it, positioning ETFs as passive investment tools.

What sets an ETF apart is their trading mechanism. ETF funds are listed in stock exchanges and trade like shares of companies. While traditional mutual funds have their value determined once daily, ETF mutual fund operate like regular stocks on exchanges, with their prices fluctuating in real-time based on buying and selling activity. This price is anchored to the real time indicative net asset value (iNAV) of the stocks the ETF holds but the market price can deviate significantly from iNAV depending on bid ask spreads and liquidity of the ETF. The design of an ETF offers greater liquidity throughout the trading day, enabling investors to take advantage of intraday price movements and much lower costs,compared to many mutual fundschemes, making them a preferred choice for many investors.

As discussed, ETF funds are expected to replicate a particular index, striving to mirror its performance. This means that when you purchase units of an ETF, you are actually investing in the benchmark market index.

It is also important to note that buying or selling ETFs is similar to trading in stocks. Their prices fluctuate throughout the trading hours based on demand and supply dynamics and changes in the value of their underlying assets. What sets ETF apart is the role of market makers—these are specialised brokers appointed by the AMCs to ensure smooth trading. They give a dual quote (bid / offer) —indicating buying and selling prices—to maintain liquidity and ascertain trades are fair and closely aligned to the Net Asset Value (NAV). The purpose of the market maker is to ensure that there is no major disparity in the price of the ETF and the iNAV of the ETF or Exchange Traded Fund.

In essence, ETFs operate in the stock exchange environment with their distinct ticker symbols just like stocks. Their pricing information remains accessible during trading hours, ensuring transparency for investors.

Types of ETFs

• Stock Market ETFs: These are the most common types of ETF funds and track a particular broad market index, such as the S&P BSE Sensex or the Nifty 50.
• Bond ETFs: These ETFs invest in bonds, aiming to provide exposure to the bond market’s different sectors. As per current SEBI regulations, ETFs can only invest in Government bonds, State Development Loans (SDLs) and PSU Bonds.
• Commodity ETFs: These ETFs are designed to track a single commodity like gold, silver etc.
• Sector and Industry ETFs: These ETF funds provide targeted exposure to specific industry sectors of the economy, like technology, healthcare, finance or banking.
• Strategy ETFs: These provide exposure to different investment strategies like Quality, Dividend Yield, Low Beta, Alpha etc.
• International ETFs: International ETFschemes focus on markets outside of India, like the Nasdaq 100 or the S&P 500, etc.

Therefore, when investing in an ETF or Exchange TradedFund, it is crucial to understand the portfolio construction methodology and the index constituents. You should ensure the risk profile of your ETF is aligned with your risk appetite.

Benefits of Investing in ETFs

• There are two kinds of risk in equity investments – systematic risk or market risk and unsystematic risk. Systematic risk affects the entire market / asset class. Systematic risk is uncontrollable and cannot be reduced through diversification. Unsystematic risk is the risk associated with specific stocks or sectors. Unsystematic risk can be diversified by investing in a sufficiently large portfolio of stocks across industry sectors.
  
  Actively managed mutual funds have both systematic and unsystematic risk. While active funds reduce unsystematic risk through diversification, they have unsystematic risks because they have to be overweight or underweight on some stocks versus the benchmark index in order to beat the index. This gives rise to unsystematic risks. If the overweight stock in an active fund underperforms versus the benchmark, the active fund will also underperform versus the benchmark.
  
  There is no unsystematic risk in an ETF since they are not overweight or underweight on any stock or sectors. Stocks in the underlying portfolio of an ETF have exactly the same weights as they have in the index. An Exchange Traded Fund is only subject to systematic or market risk.
• Fund managers of actively managed mutual fund schemes may have human biases and can make errors of judgment. There is no human bias in ETF mutual fund since they aim to replicate the index.
• Total Expense ratios (TER) of Exchange Traded Funds are much lower than actively managed mutual fund schemes. TERs have direct impact on a scheme’s performance since TERs are deducted from the market value of the underlying securities to arrive at the scheme’s NAVs. In order to match or outperform ETF returns, an actively managed fund with same benchmark index will have to outperform the benchmark index by a margin that in percentage terms is as much as the difference in TER of the active fund and Exchange Traded Fund. For example, if the TER of an ETF is 0.1% and that of an active fund with the same benchmark market index is 2%, then the active fund will have to beat the benchmark by 1.9% in order to match the performance of the ETFor Exchange Traded Fund.

Risks of ETFs

It is most important that for every instrument where you invest, make sure to always understand the risks that may come with it.

• Market Risk: Like any market-linked instrument, ETF funds are exposed to market volatility, and there’s no guarantee of returns.
• Tracking Error: There can be discrepancies between the ETF’s performance and the underlying index it’s trying to replicate, leading to potential losses. Most often, the difference in tracking error is due to the expense. Impact cost can be another factor leading to tracking errors. Impact cost is the price associated with carrying out a transaction for a particular index or securities with certain order size. Suppose market price of a stock is Rs 100, but if an Exchange Traded Fund purchases the stock in very large quantities, then price of the stock may go up by Rs 1, and the ETF may have to buy the stock at Rs 101. This can be another source of tracking error. Another source of tracking error can be circuit breakers.
• Liquidity Risk: While popular ETFs are quite liquid, some niche or less popular ETFs might face liquidity challenges. If an ETF is not very liquid, you may face challenges in finding buyers at the right price in extreme market conditions. In extreme market conditions you may be forced to sell units of your illiquid ETFs at a significant discount to the iNAV. Always check the trading volumes of an ETF. An Exchange Traded Fund with high trading volumes will be more liquid than an ETF with low trading volumes. You will get information on trading volumes of your ETFs in the websites of the stock exchanges e.g. NSE, BSE etc.

There are three steps to investing in ETFs. The first step is to open a Demat and Trading Account. To invest in ETFs in India, one needs a Demat and trading account with a brokerage firm. In the second step, you should do adequate research if the ETF is suitable for you. Different ETFs cater to different investment goals. Researching and choosing an ETF that aligns with your objectives and risk appetite is essential. You should consult with your financial advisor if you need help in selecting an Exchange Traded Fund which is suitable for your investment needs and risk appetite.

Once you’ve identified the ETF you wish to invest in, you can buy it during trading hours, just like you’d purchase a stock. This is the third step. You can place market orders, limit orders, or stop-loss orders. The final step is to regularly monitor your ETF investment. Although ETFs are generally passive investments, monitoring their performance and making adjustments, if necessary, is crucial.

No, ETF or Exchange Traded Funds do not pay dividends (Dividend in mutual funds are described as IDCW, the full form of which is Income Distribution cum Capital Withdrawal).However, dividends paid by stocks in an ETF’s underlying portfolio are reinvested in the same portfolio. Reinvestment of these dividends, benefits investors since they benefit from higher growth due to compounding affect i.e. profit earned on profits.

The taxation of ETFs depends upon the asset class. ETFs investing equity or equity related securities enjoy equity taxation. Short term capital gains (holding period of less than 12 months) are taxed at 15%. Long term capital gains (holding period of more than 12 months) are tax free up to Rs 1 lakh in a financial year and taxed at 10% thereafter.

ETFs investing in non equity assets e.g. debt, money market, commodities, international stocks etc, are treated like debt funds from a taxation standpoint. Capital gains from such ETFs are added to the income of the investor and taxed as per the income tax slab.