ETF: Complete Guide to ETF Funds

What are ETFs?

We can consider an ETF as a basket that holds several securities that tracks one or more underlying assets. By nature, it is close to mutual funds, but listed with the exchanges and traded in the market like stocks. It is an index fund that follows a benchmark index irrespective of market movement.

An ETF is like a portfolio, containing different types of investments – stocks, commodities, bonds, and more, to create a well-balanced basket. An example of a popular ETF is SPDR S&P 500 ETF (SPY), which tracks the S&P 500 index. ETF funds are highly liquid, and prices of these funds move with the market trends. This allows investors to buy or sell them any time during trading hours.

ETF funds were introduced in India in 2001.  The first ETF was NIFTY BEES (Nifty Benchmark Exchange Traded Scheme) based on NIFTY 50 launched by Benchmark Mutual Funds.

Types of ETFs:

  1. Commodity ETFs– Commodity ETFs give you exposure to precious metals like gold and silver, agricultural products, and natural resources such as oil and gas. It is important to note that through a commodity ETF, you do not actually own the physical asset. You have ownership of a series of contracts that are backed by commodities.
  2. Sector ETFs– The other name of it is Industry ETFs. It tracks a particular industry, such as technology, energy, or finance. Investors, analysts, and economists use the Global Industry Classification Standard (GICS) to define sector classification as the primary financial industry-standard metric. It is a method to assign each company to a specific sector. Index providers such as MSCI and Standard and Poor’s collectively have designed GICS. The hierarchy of GICS begins with 11 sectors and is delineated further into 24 industry groups, 68 industries, and 157 sub-industries. 
  3. Bond ETFs– It includes government bonds, or other typical investment tools that qualify as bonds.
  4. Currency ETFs– It allows you to invest in foreign currencies like EURO or Dollar
  5. Inverse ETFs– It involves a practice called shorting of stocks, which means selling shares that are expected to fall and repurchasing them at a lower cost.
  6. Global Index ETFs –It gives investors exposure to both developed and emerging markets to optimise their portfolio.

In developed countries, the ETF market is primarily dominated by institutional investors, but in India, retail investors enjoy the larger market share. The primary distributors of ETFs are the banks, who find it easier to sell open-ended Mutual Funds like funds. If you want to sell or purchase ETFs, you need a DEMAT account, or you can buy from the banks.

Read More About Types of ETF

Benefits of Investing in ETFs 

These are the benefits of investing in ETFs:

  1. Diversification: ETFs provide instant diversification. These funds track an index from a specific sector and invest in the stock basket similar to the index. It helps reduce the risk associated with investing in a single stock or asset.
  2. Liquidity: ETFs trade on the stock exchange like regular stocks, allowing investors to buy and sell them at market prices. The high liquidity of ETFs offers flexibility and the ability to execute trades quickly.
  3. Transparency: ETFs need to disclose their holdings daily, which gives investors a clear view of the underlying asset. Transparency allows investors to make informed decisions. 
  4. Low expense ratio: ETFs have a lower expense ratio than most mutual funds, which allows investors to access a diversified portfolio at a low cost.
  5. Tax efficiency: ETFs experience fewer capital gains distributions compared to mutual funds, offering investors a tax-efficient investment option. 

Risks of ETFs 

ETFs also come with a set of risks:

  1. Market risks: ETFs invest in a portfolio of assets such as bonds, stocks, commodities etc. Any change in asset price due to market conditions, economic factors, and investor sentiment also affects the value of the ETF. If there is an overall market downturn, the price of the ETF will also decrease.
  2. Trading costs: If you invest frequently, investing in no-load funds can decrease the total cost of investing.
  3. Illiquidity: ETFs are typically liquid, but some ETFs are not highly liquid like others. Some ETFs have low trading volume and a wide bid-ask spread, which makes it difficult to trade them.
  4. Tracking error: As products, ETFs follow an index and replicate its returns. However, due to factors like transaction costs, management fees, and tracking methodology, the ETF’s returns can be different from the index. It is called a tracking error. 
  5. Settlement dates: It takes two days to settle ETF transactions, which means if you are selling ETF units, your money will not be available for reinvestment for 2 days. 

ETFs vs Stocks

Stocks are a medium to show ownership interest in a company, whereas ETFs are a collection of investment vehicles decided by the fund manager that can be traded in the market like stocks. Stocks give you more control over your investment, but ETFs give you greater market exposure.

Read More About ETFs vs Stocks

ETFs vs Mutual Funds

Mutual Funds (MFs) and ETFs are similar on many grounds, but there are a few dissimilarities, especially in the ways both are managed.  Here is a crucial difference,

ETFs are traded in the market like stocks throughout the day, but MFs can be purchased at the end of the day based on calculated NAV value. MFs are also actively managed by portfolio managers; on the other hand, ETFs are indirectly managed based on a particular market index.

Besides, ETFs funds charge lower annual fees as compared to traditional mutual funds investment.

Read More About ETFs vs Mutual Funds

ETFs vs Index Funds

You can exchange ETF funds anytime during trading hours, but Index Funds are purchased or sold only at the beginning or end of a trading day.

ETFs are also more tax-efficient than index funds. When you sell ETF funds to another buyer, the money comes directly to your account. But in case of Index funds, you need to redeem it, which means capital tax is levied on it.

Read More About Index Funds vs ETFs

Are ETFs good investments?

It is a good choice since it allows investors to diversify their portfolios immediately.  Moreover, it is cheaper than Mutual Funds and Index Funds and has high liquidity like stocks. Some experts also believe that ETFs make an excellent option for young and new investors, who want to invest in the market without the headache of monitoring trends every time.  But there are a few things to keep in mind while considering it as an investment option.

  • ETF funds will cost you more than stocks. If you are planning to invest, ask about all the fees in advance
  • ETFs offer your diversification, but it doesn’t hedge from volatility
  • Leveraged ETFs experience value decay over time even when an underlying asset shows an uptrend
  • ETFs offer you less control over taxable income
  • With ETFs, you have less control over choices of assets
  • There can be a difference between the price of ETF and the values of underlying assets
  • Often ETFs are linked to benchmark indexes which means they aren’t allowed to outperform indexes

When Investing In ETFs Make More Sense Than Picking Stocks?

Stocks give you more control over your investment and higher return than other asset classes. But in some situations, opting for ETF investment is a sensible thing to do, like in the following cases,

  • Sectors that have marginal dispersion in return; all the companies from the industry generate similar returns. It gives no advantage to the stock pickers to select one company stock over the others
  • When stocks from a sector offer disperse return, but investors aren’t able to identify the cause behind the erratic drive

ETFs are professionally managed pool funds. It gives you the advantage to invest in a sector as a portfolio. So, when stock picking becomes difficult, investing in ETF makes more sense.

Types of income on ETFs

To be able to define the tax on an ETF, we need to define the types of income.

Dividend:

A dividend is a distribution made by a company to its shareholders out of its profits. It can be viewed as a reward from the company for investing in its equity.

Capital gains:

Gains from the transfer of capital assets are regarded as capital gains for income tax purposes. A gain made on a sale equals the difference between the purchase price and the sale price. Gains on the sale of stock are known as capital gains, and they are realized at the point of sale. Capital gains in India are taxed according to your period of holding.

How is an ETF taxed in India?

Since we have defined both income streams, let’s look at how the ETF is taxed in India.

Taxation of dividends:

As per the current tax regime, dividends from exchange-traded funds are taxed as per the applicable slab rates. The company or exchange-traded fund will withhold tax @10% for dividend income exceeding Rs. 5,000.

Taxation of capital gains:

As stated earlier, the taxation of capital gains depends on the period of holding of your assets.

For an equity-oriented exchange-traded fund, units held for less than 12 months are subject to short-term capital gains, and units held for greater than equal to 12 months are subject to long-term capital gains.

Similarly, for gold and other exchange-traded funds, units held for less than 36 months are subject to short-term capital gains, and units held for greater than equal to 36 months are subject to long-term capital gains.

Equity Oriented ETF:

Short-term capital gains are charged at 15% as per Sec 111A of the Income Tax Act.

Long-term capital gains are charged at 10% over and above Rs 1 lakh as per Sec 112A of the Income Tax Act. You should note that no indexation benefit will be available for such gains.

Gold ETF and Other ETF taxation:

Short-term capital gains are charged at slab rates applicable as per the Income Tax Act.

Long-term capital gains are charged at 20% as per Sec 112 of the Income Tax Act. You should note that indexation benefits will be available for such gains.

Margins for Traditional exchange-traded funds (ETFs)

An exchange-traded fund (ETF) can be managed actively or passively. A passively managed exchange-traded fund (ETF) seeks to replicate the performance of a selected benchmark, like the S&P 500 Index or the Dow Jones Industrial Average (DJIA). An index exchange-traded fund (ETF) is a cost-effective approach for investors to acquire exposure to a large basket of equities while generating returns comparable to the general performance of the market.

Traditional exchange-traded funds (ETFs) are subject to the exact margin requirements as stocks under the guidelines established by FINRA. For first acquisitions of margined securities, a broker can lend up to 50% of the purchase price of the assets. After then, the equity in the borrower’s account cannot go below 25 per cent of the total loan amount.

ETFs with a high degree of leverage

Maintenance margin requirements for non-conventional ETFs, such as leveraged ETFs, are more strict than standard ETFs. A leveraged exchange-traded fund (ETF) seeks to deliver daily returns 2x or 3x the returns of the underlying index that it monitors.

They rely on derivatives (mostly futures and swap contracts) to accomplish their daily objectives. Taking one example, the ProShares UltraPro QQQ ETF seeks to achieve daily returns three times greater than those of the Nasdaq 100 Index.

FINRA regulatory notices from 2009 state that the maintenance requirement for leveraged exchange-traded funds (ETFs) is 25 percent multiplied by the amount of leverage employed, with the maximum amount exceeding 100 per cent of the value of the ETF in question.

Example: The maintenance requirement for a 2x leveraged long ETF would be 50%, or 2 x 25% of the ETF’s assets under management. The maintenance needed for a 3x leveraged long ETF would be 75 per cent, which is three times the current 25 per cent.

Inverse ETFs and Leveraged Inverse ETFs are two types of inverse ETFs.

Inverse exchange-traded funds (ETFs) are designed to generate daily returns that are the inverse of the movement of an underlying index, as the name implies. For example, the Direxion Daily S&P 500 Bear 3x Shares ETF, which seeks to move 300 per cent in the opposite direction of the performance of the S&P 500 Index, is a good illustration.

Leveraged inverse ETFs operate in the same way as traditional inverse ETFs, with the addition of derivatives to achieve their daily target. Maintaining inverse leveraged exchange-traded funds (ETFs) incurs a maintenance requirement equal to 30 percent multiplied by the degree of leverage employed but not exceeding 100 percent of the ETF’s market value. Maintenance requirements for a 1x reverse ETF, for example, would be 30% or 1 x 30% of the fund’s total assets under management. The minimum requirement for a 3x leveraged inverse ETF would be 90 percent, three times the minimum requirement of 30 per cent.

ETF Trading Strategies:

Systematic Investment Plan (SIP)

An SIP strategy requires you to invest a fixed amount of money at the same time each month in an ETF of your choice, irrespective of the price that the ETF is trading for. When done for a long enough period of time, you can benefit from the rupee cost averaging phenomenon.

Swing trading

Swing trading basically entails trying to capture the short-term price movements of an ETF for a few days to weeks. The high liquidity that ETFs enjoy combined with the freedom to buy and sell ETF units throughout the day makes them a viable ETF strategy.

Sector rotation

Sector rotation ETF investing strategy involves picking the sectors that are currently in demand and doing well. For instance, in view of the current COVID-19 situation, pharmaceutical stocks are having a really good run in the market. ETFs can also be used to profit off seasonal trends.

Short-selling

Short-selling entails selling an ETF for a higher price and then buying the same ETF back for a lower price. The difference between the selling price and the buying price would be the profit that you get to enjoy. Shorting an ETF is a great way to experience some returns in a market that’s on a downtrend. 

Hedging

Since ETFs tend to closely track a sector, an industry, or an index, they act as great instruments for hedging risk. For instance, let’s assume that you have an open call position on an index like the Nifty 50. You can use a corresponding index ETF like the Nifty 50 ETF to protect your option position from downside risk. Such a hedging strategy would require you to short-sell the Nifty 50 ETF. This way, you can protect your index option position from going into losses.

Also Read More About ETF Terminology

How can you invest in an ETF?

To invest in ETFs, you need to have a trading account as well as a Demat account with a stockbroker. Once you have these in place, you can pick an ETF that aligns with your investment goals. Exposure to international markets, investment period, and willingness to take on risk are all factors to be considered while choosing an ETF. Once you have a clear vision of this, you can buy or sell your ETF during market hours and watch your money grow.

FAQs

Are ETFs good for beginner investors?

Yes, ETFs are inexpensive ways for investors to get exposure to various asset classes such as stocks, bonds, currencies, and commodities. It is inherently diversified, which offers better risk-adjusted returns.  

How many ETFs should you hold?

Investing in ETFs is a personal decision. Consider diversifying in terms of asset classes, regions, and other factors.

How do ETFs work in terms of tracking an index or benchmark?

ETFs often aim to replicate the performance of a specific index or benchmark. They do it by investing in a similar mix of assets as an index.

What types of ETFs are available?

The following types of ETFs are available:

  • Equity ETFs 
  • Bond ETFs
  • Commodity ETFs 
  • Sector-specific ETFs
  • Thematic ETFs

Are there tax implications associated with ETF investments?

Yes, the capital gain from ETF investments is taxed as per capital gain tax rules. The tax implications are decided based on the asset and holding period.