Exchange-Traded Fund (ETF): and its Various Features

If you look at the mutual fund flows in India in the last few months, there has been a sudden surge of interest in exchange traded funds or ETFs. What exactly are these ETFs and how do they add value to investors.

What is this concept of etf and how is it different from mutual funds?

Exchange traded funds (ETFs) are a popular form of passive investing in the world. In India ETF investing is just about catching up but the pick-up has been quite rapid. How does an ETF work? The fund AMC that is sponsoring the ETF will invite institutions to subscribe to their ETF portfolio by buying shares reflecting the Nifty (in case of a Nifty ETF) or any other underlying benchmark. Then this entire corpus created in the same proportion as the Nifty components in the index and these are converted into small units and sold to retail investors. It is these units that are traded on the stock exchanges.

There is an interesting difference between mutual funds and ETFs. Unlike mutual funds which are originated and redeemed by the fund house or AMC, the ETFs are traded in the secondary market like shares and their availability is based on liquidity. ETFs are closed ended and any purchase or sale only changes the ownership and does not change the basic corpus of the ETF. ETFs can be held in your demat account and sold and bought and through your trading account.

Are etfs only available on indices like nifty and sensex? 

No, indices are only one of the many different types of ETFs that are available. Of course, index ETFs are very popular among retail investors. However, ETFs are available in 4 categories. Firstly, there are the index ETF that are benchmarked to the Nifty or the Sensex. Secondly, there are gold ETFs indexed or benchmarked to the market price of gold, typically 24 carat gold.

Thirdly, there are sectoral or thematic ETFs which are benchmarked to a portfolio of stocks in the particular industry; so you have banking ETFs, commodity ETFs etc. Lastly, there are international ETFs which invest in funds abroad; these are normally funds sponsored by their parent based in the US/Europe/Japan. ETFs are also available in the form of debt ETFs which are now becoming quite popular in India?

Is it true that ETFs can be bought and sold on the stock exchange?

That is the unique feature of these ETFs. Typically, ETFs are listed and traded on the stock exchanges like any other stock. There are buyers and sellers and the price is determined based on the demand and supply and of course, based on the underlying value of the index or commodity in question.

Like any stock or bond or other assets that are held in demat, each ETF will also be assigned a unique ISIN number and you can therefore hold these ETFs in your demat account the same way as you hold other shares and securities in your demat account. There is no separate arrangement required for ETFs. They can be bought and sold through your normal equity trading account. It is as simple as that.

When I put my money in a gold ETF or index ETF, is the money safe?

Obviously, there is the market risk or price risk that you have in any stock or commodity. That is there in the case of ETFs also. You must first understand what the ETF sponsor does with the money? When you are invested in gold ETFs, an equivalent amount of gold is held in a gold custodian bank. Typically, it is a large specialized institution like the Bank of Nova Scotia, Canada which acts as the custodian bank and holds equivalent physical gold to back these gold ETF units. That means that your gold ETFs are fully backed by physical gold in the vaults of the custodian bank. These are ETFs are regulated by SEBI. That should hopefully answer the question of safety.

How low are the expense ratios in ETFs?

One of the big advantages of the ETF as an investment avenue is that the expense ratio is substantially lower that active funds. ETFs have a much lower expense ratio compared to other active mutual funds. On an average, Indian mutual funds have an expense ratio in the range of 2.25%-2.50% whereas an ETF will have an expense ratio of less than 0.50%. Since the ETFs are benchmarked to an index, there is no active management involved. The only thing to be done is to manage the tracking error.

How are etfs useful in diversifying the portfolios of investors?

ETFs can be an extremely useful tool for diversifying your portfolio risk. For example, if you are heavily into equities and debt, you can diversify by buying gold ETFs. On the other hand, if you want to reduce your exposure to debt and shift to equities, a simple way to do it is to buy index ETFs that are passive and also safer in comparison.

Are there any risks in investing in ETFs?

Obviously, this is a market linked product, so there is always an element of risk involved. Overall, there are 3 risks of ETFs you must be fully conscious of. Firstly, this is a market product and hence it is subject to the fluctuations of the market like any index, commodity or stock. While the trading starts around the indicative NAV, actual prices may fluctuate with the market conditions and away from the underlying asset price.

Secondly, bid-ask spreads on ETFs could widen adding to your risk, especially in the case of ETFs that are not too liquid or where adequate market support is lacking. Lastly, there is tracking error risk that your ETF may not precisely reflect the underlying index, which is what the ETF is supposed to do in the first place.

Can you explain the entire process flow of buying and selling the ETFs

Every ETF will have an indicative NAV around which the ETF will get traded. This NAV is based on the underlying asset, which can be gold, equity index or debt index. Depending on market conditions, you can place an order to buy an ETF on your online trading terminal itself. For example gold ETFs trade normally in units of 1 gram so you can buy 1 unit of gold for around Rs.4,800 as a ballpark figure. This will fluctuate during the day based on the gold prices.

Once you have purchased the ETF, these ETF units will get credited into your demat account on T+2 day, i.e. 2 working days after the actual trade on the exchange. When you want to sell the ETFs, you can sell it on your trading interface like any other equity. If it is an offline order you need to ensure that the DIS is deposited on time. An easier way is to either give power of attorney to your broker or to use the NSDL or CDSL facility to authorize the transaction online. On T+2 day, the proceeds of your sale will be credited to your designated bank account. The time can longer in case of Fund of Funds or international ETFs.

Can you tell me the tax implications of an ETF?

For understanding the tax implications there are two separate classes of ETFs that you must focus on. Let us look at the tax implications separately.

Tax implications for index ETFs and sectoral ETFs…

For tax purposes, under the Income Tax Act, index ETFs and sectoral ETFs are treated in exactly the same way as equity funds. That means any gains will be classified as short term capital gains if held for less than 1 year and will be taxed at 15%. If these ETFs are held beyond 1 year then it becomes long term capital gain and under the new rules will be taxed at 10% flat on the gains, after the basic exemption of Rs.100,000 per year.

Tax implications for Gold ETFs, Debt and International ETFs

For taxation purposes, gold ETFs, debt ETFs and international ETFs are all treated as non-equity ETF products and taxed accordingly. That means it will be short term gains if held for less than 3 years and will be taxed at your peak rate of incremental tax rate applicable. If held for more than 3 years then it will be long term capital gains and will be taxed at 20% of indexed capital gains. These rules are subject to modification from time to time.

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