Start Investing in ETFs

What is an ETF?

An ETF or exchange-traded fund is an investment that consists of a basket of assets like equity stocks, bonds, other fixed-income securities, commodities or currencies. ETFs in India typically track market indices like the Nifty 50, BSE Sensex, and sectoral indices, among others.

Like stocks, ETFs can also be purchased and sold on exchanges like the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). This is why ETFs are considered marketable securities. Their liquidity makes it easier for investors to buy and sell ETF units as required.

ETF investments in India may be suitable for conservative, moderate and aggressive investors because they include a range of underlying assets, from equity stocks and bonds to commodities and currencies. They are also passively managed as they simply track the benchmark index. This leads to lower expense ratios and improved cost efficiency, especially over the long term.

Types of ETFs

Exchange-traded funds are categorised into different types based on the assets they track. Here is a quick overview of some of the most common types of ETF funds in India.

1. Equity ETFs: Equity ETFs are designed to track the performance of a broad-market or a sectoral equity index, such as the Nifty 50, Sensex, Nifty Bank or Nifty Infrastructure. These funds provide low-cost exposure to the equity markets and are popular choices for long-term wealth creation through ETF investment in India.
2. Debt ETFs: Debt ETFs, also known as fixed-income ETFs, track the performance of debt indices like the NIFTY 1 D rate Index, NIFTY 4-8 yr G-Sec Index or Nifty 8-13 yr G-Sec Index. Investing in the top exchange-traded funds from this segment could be suitable if you are risk-averse and are looking for stable returns, liquidity and diversification.
3. Commodity ETFs: Commodity ETFs track the performance of physical commodities like gold and silver. These funds enable you to capitalise on the price movements of these precious metals without directly owning them. Gold exchange-traded funds, especially, are the most popular among the list of ETFs in India.
4. Global ETFs: Global ETFs track the performance of international indices like the NASDAQ 100 or HangSeng. These exchange-traded funds allow you to gain exposure to top international stocks and leverage their wealth-creation potential.

How do ETFs Work?

ETFs in India are unique investment vehicles that pool funds from multiple investors and invest them in a diversified portfolio of assets. Since they are designed to track a market index, their portfolios feature the same assets that constitute the index they track in an identical proportion and weightage. For example, a Nifty 50 ETF will consist of all the stocks present in the Nifty 50 market index in the same proportion and weightage.

One of the primary features of ETF funds in India is that they are listed and traded on the stock exchanges. Like individual stocks, interested investors can freely buy and sell units of any exchange-traded fund during market hours. As units are bought and sold through the trading day, the price of an ETF changes accordingly.

As exchange-traded funds are passively managed, the fund manager rarely makes any adjustments to the portfolios. The only time there is any change in the funds’ constitution is if there is a change in the index they track. In such cases, the manager makes minor adjustments to the portfolio to ensure that the funds align with the tracking index. Thanks to such passive management, ETF investments are cost-effective with low expense ratios.

ETFs vs Mutual Funds

Exchange-traded funds and mutual funds are among the most popular investment options for long-term wealth creation. Although they share a few features, these investments differ in several aspects. Let us look at the key distinctions between ETFs and mutual funds.

Factors to Consider When Choosing an ETF

As an investor, you must evaluate the performance of exchange-traded funds before investing in them. This way, you can easily identify the best ETFs that match your requirements. Let us look at some of the key performance metrics you must thoroughly analyse.

1. Expense Ratio: The expense ratio is the fee that an asset management company charges for managing a mutual fund or an ETF. It is represented as a percentage of the total amount you invest and is levied annually. Top ETF funds usually have low expense ratios, which make them more attractive due to their cost efficiency.
2. Fund Composition: Fund composition refers to the assets within an exchange-traded fund. When evaluating the best ETF funds, remember to check if the fund composition aligns with your financial goals and risk tolerance.
3. Assets Under Management (AUM): Assets under management (AUM) refers to the total market value of all of the assets within an ETF and indicates the size of the fund. Top exchange-traded funds usually have substantial AUMs, which indicates better stability and liquidity.
4. Sharpe Ratio: The Sharpe ratio is a metric that represents the risk-adjusted returns of an ETF. A higher Sharpe ratio is favourable since it indicates better fund performance compared to the level of risk it undertakes.
5. Beta: Beta is a metric that indicates just how sensitive an ETF is to market movements. A beta of 1 means that the fund moves in line with the market. A value below or above 1 indicates that the fund is less or more volatile than the market. Beta can help you identify the level of risk associated with ETFs in India.

Risks Associated with ETFs

Exchange-traded funds come with certain risks you must consider before investing in them. Here is a quick overview of some of the risks that are inherent to these investment vehicles.

1. Market Risk: One of the most significant risks you need to be aware of is market risk. The value of an ETF today depends on the performance of the asset it tracks. For example, the value of an ETF unit will rise if the value of the underlying asset rises and vice versa. Market risk is particularly high in equity and commodity ETFs, where volatility can significantly impact returns.
2. Illiquidity: Although top ETF funds typically have high liquidity, there may be a few funds with low trading volumes. Illiquidity can make it difficult to buy or sell units at favourable prices or at the right time.
3. Tracking Error: Tracking error is the difference between the return of an ETF and the index it tracks. Even the best ETF funds have tracking errors due to various factors like fund management costs, cash holdings and market inefficiencies. Funds with higher tracking errors typically produce returns that are much lower than their benchmark index.
4. Currency Risk: Currency risk is the risk of losing ETF investment value due to fluctuations in currency exchange rates. This risk only affects exchange-traded funds that invest in international markets. Depending on the direction of the foreign exchange rate movement, the returns can either be favourable or unfavourable.

Tax Implications of ETF Investments

The taxation of ETFs depends on the nature of income, the type of ETF and its holding period.

1. Tax on Dividend Income: Dividend income earned from any fund in the list of ETFs in India is included in your total annual income. It is taxed as per the income tax slab rate applicable to you.
2. Tax on Capital Gains: If you sell your ETF holdings for a higher price than the cost of investment, you earn profits that are classified as capital gains. They are taxed differently, depending on the type of ETF and the holding period.