Exchange Traded Fund or ETF is an investment option which invests pooled funds in diversified securities including bonds, equity, commodity, an index or a bouquet of equity assets such as an index fund. The ETF is marketable security in itself i.e it can be traded on stock exchanges similar to the equity stock of companies, unlike mutual funds.
Since exchange-traded funds are listed and traded on bourses, they are prone to price changes as per the value of underlying assets. Another key point of difference between ETF and mutual funds is the fact that ETFs feature a higher degree of liquidity in comparison to mutual funds as they can be bought or sold with greater ease.
Additionally, an ETF also tends to feature significantly lower management fees as compared to mutual funds. Being market-traded security, ETFs do not have a NAV or Net Asset Value, which is unique to mutual funds. The smallest unit of an ETF is a share, which has a face value and a trading value similar to an equity share.
How do ETFs work?
Because an ETF usually represent a basket of products/assets, this type of investment tends to own the assets underlying the fund. Such assets include but are not limited to company stocks, oil futures, gold, foreign currency, and bonds.
In India, gold and index-linked ETFs are the most common types available to individual investors. Subsequently, the ETF divides the total assets it owns into smaller units termed as shares, which can be traded on the exchange. Thus the current trading value of an ETF is based on the applicable value of net assets that the Exchange Traded Fund owns at that point of time.
For example in the case of a gold ETF which primarily holds gold bullion as the underlying asset, changes in the price of gold will cause a corresponding change in the price of ETF shares during the course of the trading day.
It is, however, important to note that unlike a company share, which denotes part ownership of the equity of the company an investor is invested in, shareholders of an ETF cannot stake a claim of partial ownership to the underlying assets of the exchange-traded fund.
However, the shareholders of an ETF are liable to receive profits earned from the underlying assets in the form of dividends or interest earned.
Moreover, in the case of ETF liquidation, the shareholders may also receive a residual value. As mentioned earlier, ETFs can be bought and sold on stock markets just like company shares, hence in layman terms, an ETF may be considered similar to a mutual fund that can be bought and sold on the stock exchange and whose trading value can change in real time.
Benefits of ETF Investments
The first ETF was launched way back in 1993 in the US. Since that time, this investment option has gained great popularity leading to a marked increase in the value of underlying assets held by the ETFs.
The following are the key reasons why Exchange Traded Funds have gained more and more popularity in recent times:
ETF is a cost-efficient product and often considered unique because of the low expense ratio. A lower fund management fee can generate incremental savings and therefore, increase payouts in the long term.
Diversification is another key benefit that an investor derives from ETF investments. Firstly, one can potentially choose from a wide range of ETFs which mainly differ on the basis of the underlying asset such as gold, equity or index funds. Further, certain ETFs such as an equity ETF will save you from concentration risk as it would invest its funds in a diversified portfolio of equity stocks.
Better Risk Management
Since ETFs are managed by market experts and best in class fund managers, they come with the advantage of better risk management and therefore, reducing your overall risk exposure. ETFs can also be used for hedging purposes.
Unlike mutual funds, ETFs provide you trading flexibility. You can trade the ETF on a stock exchange just like any other stock. The instant trading feature of ETF makes intraday management of the portfolio easy. ETFs can be purchased at a margin and even sold short. You can channelize your money from bonds to gold to equity in a snap.
The market trading benefit of an ETF extends well beyond the intra-day trade. Some of the other advanced trading techniques that are supported by an exchange-traded fund include trading on margin, short selling, and various speculative strategies. Though these are risky bets and not easy to perform successfully, they do provide traders with an opportunity to earn huge profits in a short time.
Tax Treatment of ETF Investments
ETF investments are subject to taxes. However, tax rates on gains from ETF investments vary based on the underlying asset of the fund. In case the underlying asset is a commodity such as gold, the taxation rules would be the same as in the case of profits generated from sale or trade of non-equity mutual fund investments. Alternately, if the underlying asset is equity-oriented such as in the case of an Index ETF, taxation rules of equity mutual funds will apply to the ETF.
Taxation of Equity-Based ETFs
The equity mutual fund rules of taxation that apply to Index ETFs involve short term and long term capital gains. Profits received from the trade/sale of ETF shares are considered as short term capital gains if the shares were held for less than 1 year from the date of allotment. Short-term capital gains are taxed at the rate of 15% in case of equity-oriented ETF as per current rules.
Long-term capital gains rule in the case of this type of ETF is applicable to shares that have been held for a period of over 1 year from the date of allotment. As per current taxation rules, long-term capital gains in case of equity-oriented investments are taxed at 10%.
Taxation of Non-Equity ETFs
Non-equity ETFs such as a gold ETF are subject to a different set of short term and long term capital gains rules. Short term gains, in this case, imply profits generated through trade/sale of ETF shares prior to the completion of 3 years from the date of investment.
Such profits are added to the annual income of the investor for the applicable year and taxed according to the applicable slab rate. Shares in ETF that are held for over 3 years from the date of allotment are subject to long-term capital gains rules. At present, non-equity oriented ETF such as a gold ETF is taxed at 10% before indexation and 20% after indexation benefits.
Q1. What types of ETFs are present in India?
Ans. Exchange Traded Funds are classified on the basis of the type of the underlying asset that the ETF is holding. At present, there are three types of ETF in India.
- Equity ETF
- Liquid (Debt) ETF
- Gold ETF
Q2. Who can invest in ETFs?
Ans. Following Categories for investment in ETFs:
- Individuals (Both Residents and NRIs)
Q3. What are the benefits of investing in the ETF?
Ans. Exchange Traded Funds operate like mutual funds only but since ETFs can be listed and traded on stock exchanges, they come with the added advantage of real-time trading flexibility. Apart from that ETFs also provide other benefits such as transparency, lower expense ratio, diversification of portfolio and better risk management.