What are Exchange Traded Funds (ETFs): Types, Features and Investment Benefits

You can choose a full-service brokerage that gives you access to a financial advisor who will provide you with advice to help you choose which Exchange Traded Funds to buy. However, the brokerage charges for these accounts can be quite high. If you are self-confident and wish to save money on fees, you may open an online trading account with a discount broker and purchase Exchange Traded Funds on your own.

To complete these requirements, you will need to provide basic KYC (Know Your Customer) documents like Aadhar Card, PAN, etc. as specified by the broker/brokerage you are opening the trading account with.

Benefits of Investing in ETF

Some key advantages of investing in exchange traded funds are as follows:

Low Investment Cost:

Compared to traditional mutual funds, the expense ratio of exchange traded funds is significantly lower. This is because exchange traded fund managers employ a passive investment approach resulting in lower fund management costs that can potentially lead to higher net returns for the investor. 

Diversification:

Exchange traded funds in India can allow investors to gain exposure to various asset classes and investment options that might not be available through conventional instruments. This type of portfolio diversification, which ETFs offer, enables investors to expand their investments into relatively new asset classes and themes like gold, silver, renewable energies, international indices and more.  

Exchange Traded Funds vs Mutual Funds: Know the Differences

Exchange Traded Funds and mutual funds have many similarities but there are some key differences one must be mindful of before investing. Key differences between equity mutual funds and ETFs include the following:

Fee Structure: 

Due to the various management techniques of these funds, the fee structures are unique. ETFs may have a total expense ratio (the proportion of fund assets spent for administrative, administration, advertising, etc.) as low as 0.05%, whereas the average expense ratio for actively managed mutual funds is around 1%. So net returns from an ETF can be higher than those offered by mutual funds for the average investor.

Liquidity:

As implied by their name, ETFs can be traded on stock exchanges. An investor can buy or sell shares throughout the day at the current market price. Additionally, ETF units may be acquired on leverage or sold short as part of an investor’s intra-day trading strategy. In contrast, mutual fund shares at a net asset value (NAV) that is calculated at the end of each trading day. So, compared to ETFs, mutual funds are less liquid as they are not suitable for intra-day trades.

Management Style:

Generally, ETFs are passively managed, whereas most mutual funds in India are actively managed. Consequently, many ETFs strive to replicate a benchmark, whereas mutual funds aim to outperform their chosen index. However, there are some passively managed mutual funds too like index funds that replicate a specific index. Such passively managed mutual fund schemes have a total expense ratio that is comparable to that of an ETF. 

Minimum Investment: 

The minimum investment for an ETF is equivalent to the cost of a single unit. In the case of some ETFs, the minimum investment can be around Rs. 3000. Typically, mutual fund investment have a minimum lumpsum investment requirement of Rs. 5,000 while SIP investments can start for as low as Rs. 100 per month.

Lock-In Period: 

ETFs in India do not have a lock-in period, however many type of mutual funds in India can have a lock-in periods ranging from a few days to a few years. For instance, some types of debt mutual funds like liquid funds typically have a lock-in period of 7 days, while ELSS tax saver mutual funds have a 3-year lock-in period. This results in greater investment flexibility for investors opting for exchange traded funds instead of some types of mutual funds.  

Should You Invest in ETFs?

The management expenses of exchange traded funds (ETFs) are often relatively low, and ETFs can offer access to more diverse themes as compared to many different types of mutual funds. However, every type of ETF carries its own specific risks, so, do take time to go through the scheme-related documentation carefully before you invest. 

Whether you choose ETFs, mutual funds, or individual stocks and bonds to construct your portfolio, it is essential to examine your goals and risk tolerance to determine the optimal asset allocation target. Only will you be able to decide if a specific ETF matches your specific investment needs.

Frequently Asked Questions (FAQs)

Q.In India, how are equity-oriented ETFs taxed?

In India, equity-oriented ETFs are treated similar to equity mutual funds and equity shares. Therefore, similar to tax on mutual funds, short-term capital gains from ETFs held for less than 1 year prior to redemption are taxed at 15% of gains. Long-term equity ETF returns are gains from units held for over 1 year prior to redemption and in such cases, LTCG rates are applicable at 10% of gains exceeding Rs. 1 lakh in a financial year.  

Q. What constitutes actively managed ETFs?

Actively managed ETFs are those that a professional fund manager oversees. Fund managers make all strategic choices about exchange traded funds to ensure that the investor get the returns they are expect.

Q. What does ETF in-kind creation and redemption mean?

ETFs in India can either be purchased on the exchange or directly from the fund house. The fund house usually creates or redeems ETF units in predefined lot sizes only. This system of creation/redemption is unique to exchange traded funds and carried out in lieu of an underlying portfolio basket (called “creation unit”) of predefined size. Once the underlying portfolio basket is deposited with the scheme together with a cash component, the investor is allotted the newly created units. When ETF units are sold back to the fund and a specific lot size is reached, the units are considered as redeemed and removed from stock market circulation.

Q. What is the distinction between ETFs and index funds?

The primary distinction between an ETF and an index fund is that ETFs may be purchased and sold during the trading day, whereas index funds can only be bought and sold at a predetermined price i.e. NAV (Net Asset Value) that is calculated at the end of each trading day.

Q. What is the underlying assets of international ETFs?

International exchange traded funds available in India typically replicate the composition of international indices like the Nasdaq 100, S&P 500, HangSeng, FTSE 100, etc. So, investment in these ETFs allows investors to benefit from the return potential of stocks of various international companies.  

Sources:

https://www.amfiindia.com/investor-corner/knowledge-center/etf.html

https://www.mutualfundssahihai.com/en/what-exchange-traded-fund-etf

https://www.merrilledge.com/article/getting-to-know-exchange-traded-funds

https://corporatefinanceinstitute.com/resources/wealth-management/exchange-traded-fund-etf/

https://economictimes.indiatimes.com/wealth/invest/how-to-invest-in-etfs/articleshow/90741548.cms

https://www.elearnmarkets.com/blog/what-are-exchange-traded-funds-etfs/#advantages

https://www.hdfcbank.com/personal/resources/learning-centre/invest/difference-between-ETF-and-mutual-fund

https://economictimes.indiatimes.com/wealth/invest/how-to-invest-in-etfs/articleshow/90741548.cms

https://learn.quicko.com/income-tax-etf-exchange-traded-funds

https://www.tomorrowmakers.com/other-investments/best-international-etfs-invest-2022-indian-investors-article