We keep hearing about new opportunities in the market like REITS, INVITS, Gold Bonds etc. but an oft-ignored asset class is the exchange traded fund or the ETF. Exchange traded funds (ETFs) are a popular form of passive investing in the world. In India ETF investing is just about catching up. How does an ETF work? Units are created benchmarked to a commodity or index and then these units are traded on the stock exchanges.
What you need to know about ETFs
ETF is much broader than what we care to consider. It is a flexible instrument that can be applied to a number of asset classes. Here are some major ETF takeaways.
- ETFs are available in 5 segments. Index ETFs are benchmarked to the Nifty or the Sensex. Gold ETFs are indexed to the market price of gold. Sectoral ETFs are benchmarked to a portfolio of stocks in the particular industry. International ETFs invest in funds abroad. Finally, Bond ETFs (like the Bharat 22 ETF) are based on a bond index underlying.
- ETFs are traded on the stock exchanges like any other stock. Buyers and sellers get together to determine the price based on demand and supply. Every ETF is assigned a unique ISIN and you can hold these ETFs in your demat account.
- How is the ETF money used? When you invest in gold ETFs, equivalent amount of gold is held in a gold custodian bank. Your gold ETFs are fully backed by physical gold in the vaults of the bank.
- ETFs have lower expense ratio compared to mutual funds. Indian mutual funds have an expense ratio in the range of 2.0%-2.5% whereas an ETF will have an expense ratio of less than 0.50%.
- There are 3 risks in an ETF. Firstly, this is a market product and subject to market fluctuations. Secondly, bid-ask spreads on ETFs widen and add to risk. Lastly, there is tracking error risk that your ETF may not precisely reflect the underlying index.
How exactly is the process flow in an ETF?
ETF has indicative NAV around which the ETF gets traded. You can place an order to buy or sell an ETF on your trading terminal. Once you purchase the ETF, on T+2 day this ETF is credited to your demat account. On T+2 day, the proceeds of ETF sale will be credited to your designated bank account.
Tax implications of ETFs
There are two sets of implications for ETFs based on their underlying assets. Let us look at them separately…
Tax implications for index ETFs and sectoral ETFs
For tax purposes 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 taxed at 15%. If these ETFs are held beyond 1 year then it becomes long term capital gain and is taxed in your hands at 10% above Rs.1 lakh of gains per year.
Tax implications for Gold ETFs and International ETFs
For tax purposes, gold ETFs and international ETFs are treated as non-equity products. That means it will be short term gains if held for less than 3 years and will be taxed at your peak 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 gains. This is where gold ETFs lose out to Sovereign Gold Bonds, as they are free of capital gains tax if held for the full tenure of 7 years.
Index Funds versus Index ETFs – How to play passive?
An index fund is like any normal mutual fund scheme. The only difference is that the fund manager just creates a portfolio that replicates an index (Sensex or Nifty). There is no element of stock selection in the index fund. The only effort the fund manager puts in here is to ensure that the tracking error is kept at the bare minimum.
An Index ETF represents fractional shares of the index. An ETF is almost akin to a closed ended fund where the funds are raised in the beginning and then the ETF creates a portfolio of index stocks at the back-end to mirror the index. If the Nifty ETF is 1/100th fractional unit then one unit of the Index ETF will roughly be available at Rs.110.00 assuming the Nifty level at 11,000. Of course in reality there will be a minor divergence to reflect costs.
The two important criteria you must consider when making the choice between Index ETFs and Index Funds are costs and liquidity. While ETF scores on low cost, the liquidity position is also increasing with more and more investors realising the benefits of investing in ETFs. So, costs and liquidity both works in favour of the Index ETFs.