An Exchange-Traded Fund (ETF) is an investment fund that mirrors an index, a collection of assets, or a commodity. ETFs can be traded on stock exchanges similarly to stocks, allowing investors to buy and sell them throughout the trading day. This grants investors the convenience of stock trading with the advantages of mutual fund investments.
What should you know before investing in ETFs? Here are essential facts and factors
ETFs unlike mutual fund schemes can be bought and sold in the open market. However, these track the equity/debt market index and commodities’ prices just like mutual funds do.
Investing in ETFs presents several benefits over traditional mutual funds, which include:
- Lower fees: These funds usually have lower fees compared to mutual funds. As ETFs are passively managed, there's no need to pay a manager for stock selection.
- Greater liquidity: The ETFs are more liquid than mutual funds, making them easier to buy and sell. Being traded on stock exchanges provides this increased liquidity, much like regular stocks.
- Diversification: The ETFs offer diversification by tracking an index comprising multiple assets. This diversification can aid in reducing overall investment risk.
What are the types of ETFs one may invest in?
The various types of ETFs are available, including:
- Index ETFs: These ETFs mirror the performance of a specific index, like the S&P 500 or the Dow Jones Industrial Average.
- Actively managed ETFs: In contrast, actively managed ETFs are overseen by managers who select individual stocks in an attempt to outperform the market.
- Commodity ETFs: Commodity ETFs follow the performance of commodities like gold or oil.
- Bond ETFs: These ETFs track a bond index, such as the Barclays Aggregate Bond Index.
How to invest in ETFs?
When participating in an ETF New Fund Offer (NFO), you will be allocated units at the specified offer price of the NFO. On the other hand, if you choose to invest in an ETF after its listing, you will need to purchase units at the prevailing market price, similar to buying shares of companies.
As opposed to the myth that investing in ETFs is a cumbersome process, investing in ETFs involves the following steps:
- Open a Brokerage Account: To buy and sell ETFs, start by opening a brokerage account. Compare different brokerages based on factors such as fees, features, and customer service to find one that suits your needs.
- Fund your account: Once your brokerage account is set up, fund it by transferring money from your bank account or writing a check.
- Select your ETFs: Consider your investment goals, risk tolerance, and time horizon when choosing the right ETFs for your portfolio. There are various ETF options available to cater to different preferences.
- Execute the trade: With your ETF choices in mind, place a trade to buy the selected ETFs. You can do this through your brokerage account's website or mobile app.
- Monitor your investments: Regularly review the performance of your ETF investments to ensure they align with your expectations. Keep track of their prices and consider rebalancing your portfolio as necessary to maintain your desired asset allocation.
Apart from the mentioned considerations, you must also fulfill the Know Your Client (KYC) requirements before investing in ETFs. This involves submitting necessary identity proof (e.g., PAN card), address proof (e.g., Aadhaar card), photographs, and other account opening requirements such as a cancelled cheque and a duly filled account opening form.
Once your KYC is verified and a Demat account is opened, you can begin investing in ETFs through your trading account. The Demat account allows you to hold your ETF units electronically, and the trading account facilitates buying and selling ETF shares on the stock exchange. By completing the KYC process and setting up the required accounts, you can proceed with ETF investments efficiently and in compliance with regulatory norms.
Bid/offer prices for the purchase/sale of ETFs
To buy or sell ETF units using your online trading account, it’s essential to comprehend bid and offer prices. The bid price represents the maximum price a buyer will pay for a stock or ETF. In simpler terms, it's the highest price at which you can sell your ETF units. Conversely, the offer or ask price is the minimum price a seller is willing to accept for a stock or ETF, and it's the minimum price you'll need to pay to buy ETF units. The offer price will be higher than the bid price, and the difference between the two is referred to as the bid/ask spread. A narrower bid/ask spread indicates higher liquidity, whereas a wider spread suggests lower liquidity for the ETFs.
Liquidity is a crucial factor to consider when investing in ETFs. You must opt for ETFs with low bid/ask spreads to ensure better liquidity. Your online trading screen will display the bid and offer prices, along with the corresponding quantities. It’s important to review these bid/offer prices before placing your buy or sell order to make well-informed investment decisions.
iNAV in ETFs is different from NAV in mutual funds
Those involved in buying and selling ETFs must be aware of the term iNAV, which stands for Intraday Net Asset Value or Indicative Net Asset Value. The NAV represents the market value of all securities held in an ETF or mutual fund's underlying portfolio, minus liabilities, divided by the total number of fund units. The iNAV provides an indication of the ETF's fair value and is a crucial data point to consider before buying or selling ETF units on the stock exchange. However, it's essential to note that the market price of an ETF may differ from the iNAV.
For equity ETFs, the mutual fund house updates the iNAV with a maximum lag of 15 seconds, providing near real-time information to retail investors. On the other hand, debt ETFs’ iNAVs are updated four times a day.
Some tips for effectively using iNAV include:
- Check iNAV before trading: Always review the iNAV before buying or selling ETF units. This will ensure you make transactions at a fair price.
- Consider premiums or discounts: Be mindful that the market price of an ETF may deviate from the iNAV. When trading ETF units on the stock exchange, you may encounter a premium or discount to the iNAV.
- Monitor ETF performance: Utilise the iNAV to track your ETF’s performance relative to its underlying index. This allows you to stay informed about your investment's progress.
By incorporating iNAV into your ETF investment strategy, you can make more informed decisions and have a clearer understanding of the ETF's fair value and performance.
Factors to consider before investing in ETFs
Putting money in ETFs should not be a random decision. Like other investment opportunities that you consider, you must check if you are choosing the right ETFs in sync with your financial goals. Before investing in ETFs, it's crucial to be aware of the following factors:
- Investment goals: Define your investment objectives, whether it's for retirement, a future purchase, or other financial milestones. Your goals will guide you in selecting the most suitable ETFs.
- Risk tolerance: Assess how much risk you are comfortable with in your investments. While ETFs are generally considered safer, different ETFs may have varying risk levels. Conservative investors may prefer ETFs tracking stable indices like the S&P 500.
- Time horizon: Determine the length of time you plan to keep your money invested. A long-term approach can withstand short-term market fluctuations, but a shorter time horizon may require more stable ETF options.
- Expense Ratio: The expense ratio represents the fee charged by the ETF's manager. It's essential to compare expense ratios among different ETFs to ensure cost-effectiveness.
- Liquidity: Consider the liquidity of the ETF, which determines how easily you can buy or sell its shares. Ensure that the chosen ETF provides sufficient liquidity to accommodate your trading needs.
- Tracking error: Evaluate how closely the ETF tracks its underlying index. Lower tracking errors indicate better alignment with the index's performance.
Once you've taken these factors into account, you can begin researching specific ETFs that align with your investment goals and risk profile. Thorough research and due diligence will help you make informed decisions about your ETF investments.
Here are some additional tips to consider when investing in ETFs:
- Thorough research: Before committing to any ETF, conduct comprehensive research to understand its investment objective, fees, and associated risks. Being well-informed will help you make smarter investment decisions.
- Start with small investments: If you're new to investing, it's wise to start with smaller amounts. This approach allows you to gain experience and knowledge without risking significant capital.
- Diversify your portfolio: Avoid concentrating all your investments in one asset or ETF. Diversifying your portfolio across different ETFs can help spread risk and increase the chances of better returns.
- Regular portfolio rebalancing: As your investments grow or market conditions change, periodically rebalance your portfolio. This ensures that your asset allocation remains in line with your investment objectives.
- Avoid panic selling: Stay calm during market fluctuations and avoid panic selling. Markets naturally fluctuate, and knee-jerk reactions to downturns can lead to potential losses. Stick to your long-term investment plan and resist making impulsive decisions.
How are ETFs taxed?
Equity ETFs are taxed as equity, while debt, commodity, and international ETFs are taxed as non-equity. The underlying asset class of an ETF determines its tax treatment.
Equity ETFs are taxed on short-term capital gains (holding period of less than 12 months) at 15 per cent, plus applicable surcharge and cess. Long-term capital gains (holding period of more than 12 months) are tax-exempt up to ₹1 lakh in a financial year and taxed at 10 per cent, plus applicable surcharge and cess, thereafter.
Non-equity ETFs are taxed differently. Capital gains (irrespective of the holding period) are added to the investor's income and taxed as per the tax rate of the investor.
Here is a table summarizing the tax treatment of ETFs:
Type of ETF
|Tax on short-term capital gains
Tax on long-term capital gains
15% + surcharge + cess
Exempt from taxes up to ₹1 lakh, then 10% + surcharge + cess
Added to investor’s income and taxed as per their tax rate
Added to investor’s income and taxed as per their tax rate
Investing in ETFs is simple and similar to investing in shares though you must consult a financial advisor to check which ETF would best suit your risk appetite and help you to reach your financial goals faster.
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