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Exchange-traded funds, commonly known as ETFs, are investment instruments that are essentially baskets of securities that trade on the stock exchanges like a normal share. Passive in nature, ETFs generally track and mirror an index, sector, theme, or assets like commodity and bonds. In India, the segment of ETFs is slowly taking off and several mutual fund houses are offering ETFs to investors. Globally, ETFs are increasingly becoming the preferred choice of investors who want to keep their investment costs low without losing out on the wealth creation journey.

ETFs are of various types including Debt or Bond ETFs, Equity or Stock ETFs, Industry-specific ETFs, Index-Specific ETFs, Commodity based ETFs like Gold and Silver, among several others. There are over 100 ETFs listed on the NSC, and these could be a viable instrument for long-term investment. ETFs are a different type of investment and investors should know the basics before adding them to their portfolios.

Here is what you need to know before investing in ETFs.

ETF vs. Mutual Funds

Quite often, investors think of ETFs as mutual funds, which is not true. Mutual Funds are also index-tracking, but they are pooled investments that are actively managed in a way that they beat the index and achieve higher performance. ETF, on the other hand, is an investment fund traded on the stock exchange. It tries to match the price movements and returns indicated in an index by assembling a portfolio that is similar to the index constituents.

Demat account

You need a Demat account to start investing in ETFs. Since ETFs are exchange-listed instruments, investing in them requires you to have an active Demat account with any financial intermediary.

Trading

As the name suggests, ETFs are traded on exchanges like any other stock. The prices of ETFs witness fluctuations throughout the trading session. Similar to how an investor can buy and sell a stock as many times as they want, ETFs, too, can be bought and sold at any time during the trading hours. ETFs are not like Mutual Funds that trade just once after the market hours end.

Liquidity issue

Since ETFs are still evolving in India and are at their initial stage, liquidity can be an issue at times. Units of ETFs may not be as easily and conveniently tradable as is the case with individual stocks. Higher the market size of an asset better is liquidity.

Expense

ETFs do entail an expense, though it is pretty low. Dramatically lower fees are, in fact, one of the major reasons that make ETFs an attractive and highly cost effective investment proposition in the long run. Against an expense ratio of as much as 2.5% in regular equity mutual funds, expenses attached to ETFs are generally less than 0.5% and can go down to as low as 0.1% in some categories.

Diversification

Since an ETF offers a basket of multiple securities, every unit provides diversification across the stocks, assets, or sectors; depending on the type of ETF. Therefore, investment in ETFs reduces the concentration risks as would be the case in an individual stock. Because of several underlying securities, ETFs stand a good chance of becoming a preferred choice for diversification.

Tax implications

Investors who sell ETFs to book profit come under the purview of capital gains tax which is calculated on the basis of the nature of the securities held by the ETF.

Taxes on equity ETFs

Capital gain taxes are of two types — short-term capital gain tax and long-term capital gain tax. The former is applied to the gains made from the sale of units within 12 months of buying them. The tax rate is fixed at 15% excluding surcharges and other cess taxes. If units are held for more than 12 months and then sold, the gains thus made are subject to long-term capital gain tax.

For equity ETFs, there is no long-term capital gain tax if the gain amount is up to Rs. 1 lakh. However, gains beyond this permissible limit will be taxed at the rate of 10% without any indexation benefits.

Taxes on gold, debt and international ETFs

The definition of short- and long-term changes for ETFs of other asset classes like Gold ETFs, Debt ETFs, or ETFs tracking international indices. For such ETF categories, long-term means 36 months or more while short-term means less than 36 months. The applicable tax rates for these exchange-traded funds are similar. There is a 20% long-term capital gain tax with indexation benefits. In case an investor sells units within 36 months, short-term capital gains, if any, will be added to their annual income, and applicable taxes will be in line with the income tax slab of the investor.

At a time when actively managed funds are finding it difficult to maintain higher alpha (more than the benchmarks) returns, investment in ETFs could turn out to be an efficient way of investment in the long term. At the same time, ETFs give investors the benefit of diversification. ERFs have the potential to be a key part of every investor’s portfolio, and you should investigate them to figure out how well they fit into your portfolio.