The BuyT Desk
The ETFs, i.e. exchange-traded funds, are a sub-category of mutual funds. They have seen an increased level of interest among Indian investors in the last five years. The amount collected from the investors is invested in a portfolio of equity shares, bonds, or gold depending on the scheme’s purpose.
What are ETFs?
ETFs are generally passive funds and track indexes such as Nifty 50, Bank nifty or Sensex. When you buy an ETF, you purchase units of a portfolio that tracks the underlying Index’s yield and return. ETFs don’t outperform their corresponding index, but their performance is aligned with the underlying Index’s performance. Like mutual funds, ETFs also have different categories like equity, bonds, liquid or gold ETFs depending on the purpose of the scheme. Apart from equity ETFs, gold ETFs are available that invest in pure gold. Investors get capital gains according to the performance of gold. Bond ETFs provide an opportunity to invest in government and non-government bonds. For investors who want to invest in international companies such as Amazon, Apple, and Microsoft, ETFs are an option based on the International Index. A Demat account is necessary to invest in ETFs.
ETFs also feature that their value changes several times in a day as they are traded on the stock exchange. The value of ETFs varies in the real-time. Therefore, investors can take advantage of market fluctuations while buying or selling in ETFs. ETFs are no longer limited to only the cap based on Nifty and Sensex. There are also options for ETFs based on sectorial indices such as Nifty Bank, Nifty IT, Nifty Private Bank, Nifty PSU Bank etc.
Comparison with Mutual Funds
The ETFs are based on a single index, and fund managers cannot change that. Therefore, their performance is almost equal to its benchmark index. The expense ratio in ETFs is much lower than that of any active mutual fund. While investing in ETFs, an investor is not required to see its past performance under any mutual fund scheme. However, in a mutual fund, the fund manager tries to ensure that the actively managed mutual fund’s performance is better than the benchmark. Fund managers include shares to the portfolio as per their understanding and expertise. The fund manager also decides the ratio of different shares in the portfolio. Often, the top mutual funds in the large-cap category have outperformed index funds or ETFs in the long-term.
Another difference between ETFs and mutual funds is that the price of ETF keeps changing according to its supply and demand. Whereas, the NAV (Net Asset Value) of a mutual fund is fixed only once in a day, at market closing, based on the money that the mutual fund has invested in the stocks or bonds.
Income Tax Liability
Investors may have to pay tax on the capital gains from selling ETFs. Taxation on capital gains from equity and other capital assets is different. A short-term investment in equity ETFs is for a year. The short-term capital gain (STCG) tax of 15% applies when you sell the ETF after 1 year of investment, henceforth, long-term capital gains (LTCG) tax applies. The long-term capital gains (LTCG) tax does not apply on the capital gains up to Rs.1 lakhs, and above that amount, the LTCG tax of 10% applies. If you invest in a bond ETFs or gold ETFs, then a period of 3 years or less will be short-term, and more than three years will be long-term. Thus, the STCG depends on the income tax slab that can go up to 30 %, while the LTCG is 20 % with the benefit of indexation. Keep in mind, additional health and education cess of 4 % is applicable too.
Who should invest in ETFs?
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ETFs are suitable for investors who have limited knowledge of capital markets and even mutual funds but want to invest in capital markets with less risk.
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Other investors who have a good understanding of capital markets can judge which sector like banking or IT will perform better than the average capital market at a specific time. However, they do not understand which shares of banking or IT sector to select, in such a scenario, sectorial ETFs like Nifty bank or Nifty IT are advantageous.
