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Exchange traded funds meaning is quite simple to understand. An ETF is an investment that brings together many assets, such as shares, bonds, or commodities, into one product. It is traded on the stock exchange, so investors can buy and sell it during market hours in the same way as shares.
Most ETFs are designed to follow an index and reflect its performance instead of trying to outperform it. Because of this, they are usually low-cost and easy to manage. One popular example is the SPDR S&P 500 ETF, which mirrors the S&P 500 index. In India, ETFs began in 2001, starting with NIFTY BEES.
Key Takeaways
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Exchange Traded Funds (ETFs) are investment products that trade on stock exchanges like shares.
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They offer diversification by investing in multiple assets through a single fund.
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ETFs are low-cost, transparent, and highly liquid compared to many mutual funds.
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Different types of ETFs suit long-term investing, trading, and hedging strategies.
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While useful, ETFs still carry market, liquidity, and tracking risks.
Types of ETFs:
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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.
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Sector ETFs – Another name for 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.
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Bond ETFs – It includes government bonds, or other typical investment tools that qualify as bonds.
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Currency ETFs – It allows you to invest in foreign currencies like EURO or Dollar
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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.
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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: Types of ETF
Benefits of Investing in ETFs
These are the benefits of investing in ETFs:
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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.
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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.
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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.
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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.
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Tax efficiency: ETFs experience fewer capital gains distributions compared to mutual funds, offering investors a tax-efficient investment option.
How Can You Invest in an ETF?
Here is a step-by-step process for investing in ETFs:
Step 1: Log in to your Angel One Demat account with your mobile number and validate with OTP. Next, enter the MPIN. Note: If you don’t have an Angel One Demat account, you can open one quickly by completing the online account opening process.
Step 2: On the homepage, click on the ETF option and choose an ETF you want to invest in.
Step 3: Now, click on buy and select one-time investment or SIP as per your convenience. One-time investment means you invest a lump sum amount, while SIP requires investing a fixed amount daily, monthly or quarterly.
Step 4: Add quantity and price as per requirement. You can adjust the price by using a limit or market order. In a limit order, you can change the price at your convenience, while market orders restrict you from changing the price.
Step 5: The final step is to click on buy, and your transaction will be executed.
Also Read: What is Demat Account
Risks of ETFs
ETFs also come with a set of risks:
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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.
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Trading costs: If you invest frequently, investing in no-load funds can decrease the total cost of investing.
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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.
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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.
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Settlement dates: It takes one day to settle ETF transactions, which means if you are selling ETF units, your money will not be available for reinvestment for 1 day.
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.
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ETF funds will cost you more than stocks. If you are planning to invest, ask about all the fees in advance
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ETFs offer your diversification, but it doesn’t hedge from volatility
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Leveraged ETFs experience value decay over time even when an underlying asset shows an uptrend
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ETFs offer you less control over taxable income
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With ETFs, you have less control over choices of assets
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There can be a difference between the price of ETF and the values of underlying assets
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Often ETFs are linked to benchmark indexes which means they aren’t allowed to outperform indexes
Why Invest in ETFs?
Many investors prefer to invest in ETFs because they offer a simple and reliable way to participate in the market without the stress of picking individual stocks. ETFs combine multiple securities into one investment, helping reduce risk while providing steady exposure to a sector or index. They are especially helpful when market trends are unclear or difficult to predict.
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When companies in a sector deliver similar returns, ETFs remove the need to select one stock over another.
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If stock prices move unpredictably and the reasons are unclear, ETFs offer balanced exposure.
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ETFs are professionally managed, making them suitable when stock selection becomes challenging.
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Choosing to invest in ETFs allows diversification at a lower cost and with less effort.
Factors to Consider Before Investing in ETFs
Before you invest in ETFs, it is important to understand a few key points to ensure your investment matches your financial goals. ETFs are simple to use, but choosing the right one makes a real difference to returns and risk.
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Investment goal: Be clear about whether you want growth, income, or diversification before you invest in ETFs.
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Asset class and sector: Check if the ETF invests in equity, bonds, commodities, or a specific sector.
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Expense ratio: Lower costs help improve long-term returns.
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Liquidity: High trading volume makes buying and selling easier.
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Performance tracking: Review how closely the ETF follows its index.
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 the 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 ₹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 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.
Equity-Oriented ETF: Short-term capital gains are charged at 20% as per Sec 111A of the Income Tax Act. Long-term capital gains are charged at 12.5% over and above ₹1.25 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 12.5% as per Sec 112 of the Income Tax Act. You should note that indexation benefits will not 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 SEBI.
ETFs With a High Degree of Leverage
Non-conventional ETFs, such as leveraged and inverse funds, are subject to stricter maintenance margin requirements than standard ETFs. Because these products use derivatives like futures and swaps to achieve their goals, regulators impose higher capital buffers to account for their increased volatility.
Leveraged ETFs (Long)
A leveraged ETF seeks to deliver multiples (e.g., 2x or 3x) of the daily returns of its underlying index. For example, the ProShares UltraPro QQQ aims for 3x the daily performance of the Nasdaq 100.
Per the guidelines, the maintenance requirement for these funds is calculated as 25% multiplied by the leverage factor:
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Leverage Type |
Calculation |
Maintenance Requirement |
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2x leveraged |
2 x 25% |
50% |
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3x leveraged |
3 x 25% |
75% |
Inverse and Leveraged Inverse ETFs
Inverse ETFs are designed to provide the opposite (inverse) return of an index. Leveraged inverse ETFs amplify this opposite movement using derivatives. For instance, the Direxion Daily S&P 500 Bear 3x Shares seeks to move 300% in the opposite direction of the S&P 500.
The maintenance requirement for inverse products starts at a higher base of 30% multiplied by the leverage factor (capped at 100% of the market value):
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Leverage Type |
Calculation |
Maintenance Requirement |
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1x inverse |
1 x 30% |
30% |
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3x inverse |
3 x 30% |
90% |
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.
Note: While requirements scale with leverage, the total maintenance margin will not exceed 100% of the ETF's market value.
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 from 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.
Read More: ETF Terminology
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Conclusion
Exchange Traded Funds are a practical option for investors who want simplicity, flexibility, and diversification in one investment. They allow access to markets, sectors, and asset classes without the need to select individual stocks. With lower costs, easy trading, and clear visibility of holdings, ETFs suit both new and experienced investors. However, it is important to choose ETFs carefully by understanding goals, risks, and costs involved. When selected wisely, ETFs can help build a balanced portfolio and support long-term financial planning. Taking time to research and invest thoughtfully can make ETFs a useful part of a well-structured investment strategy.
