Exchange-traded Funds (ETFs): A Comprehensive Guide for Beginners

November 30, 2023 Mutual Fund

Exchange-traded Funds (ETFs) are steadily gaining traction in India.

One of the major reasons for higher inflows in ETFs compared to other passive mutual funds such as Index Funds and Fund of Funds is investment from EPFO. As per the pattern notified by the government, the retirement body invests 85% of its assets in Debt and 15% in ETFs tracking S&P BSE Sensex or Nifty 50. ETFs are also slowly catching up among retail investors.

The asset under management (AUM) of ETFs in India has more than doubled from Rs 2.2 trillion as of October 2020 to Rs 5.8 trillion as of October 2023.

What are Exchange-traded Funds?

ETFs are passively managed mutual fund schemes that invest in a basket of securities such as stocks, bonds, commodities, etc. These funds aim to track and replicate the performance of a particular index, such as Nifty 50, S&P BSE Sensex, etc., by mirroring its composition.

What differentiates ETFs from other passively managed schemes like Index Funds and Fund of Funds, is that ETFs are traded on stock exchanges. Therefore, the units of ETFs can be bought or sold at the prevailing real-time NAV throughout the trading hours.

Being passively managed, ETFs entail much lower cost compared to actively managed mutual fund schemes.

Table 1: Top 10 ETFs in India by AUM

Securities quoted are for illustration purpose only and are not recommendatory
Data as of October 31, 2023
(Source: ACE MF, data collated by PersoanalFN) 

What are the types of Exchange-traded Funds available in India?

The ETF segment in India has broadened over the past few years, with mutual fund houses offering new and innovative products to help investors create a diversified portfolio. They now come in various forms and types to suit the needs of different types of investors.

Here are the different types of ETFs available for investment in India:

1) Equity ETFs

Equity ETFs offer the growth potential of equities but at a lower cost compared to actively managed equity mutual funds. The different types of equity ETFs available in India can enable investors to create a diversified portfolio of passively managed equity mutual funds.

ETFs that track equity indices such as Nifty 50, Nifty Next 50, and S&P BSE Sensex are among the most popular options available at present. Investors also have the option to get exposure in the mid-cap and small-cap segments through ETFs that track indices such as the Nifty Midcap 150 or Nifty Smallcap 250 ETF.

Mutual fund houses have also launched Factor-based ETFs that target specific drivers of returns such as momentum, low volatility, value, quality, etc. Examples include the Nifty 200 Momentum 30 ETF, Nifty 100 Low Volatility 30 ETF, and Nifty 200 Quality 30 ETF.

Equity ETFs also include schemes designed to replicate a particular sector, such as Banking, Infotech, Pharma or a theme, such as ESG, Consumption, Infrastructure, etc.

Watch this video to know the about the best mutual funds for beginners:

2) Debt ETFs

Debt ETFs are passively managed mutual funds that invest predominantly in fixed-income instruments such as corporate bonds and government bonds. These schemes track debt indices such as Nifty Bharat Bond Index, Nifty 5-year G-sec Index, Nifty CPSE Bond Plus SDL Index, etc. Notably, Debt ETFs have gained strong momentum in the last couple of years.

Investors have the option to choose Debt ETFs across various maturities and credit profiles such as Government Securities, Corporate Bonds, State Development Loans (SDLs), etc., to suit their risk profile, financial goals, and investment horizon. Since Debt ETFs are traded on stock exchanges, they offer the stability of debt instruments and the flexibility of stock investments in a cost-effective way.

3) Commodity ETFs

Commodity ETFs are those that track the prices of the respective commodities. Among these, Gold ETFs are the most sought-after options, while mutual fund houses have also turned their focus on Silver ETFs in recent years. Gold ETFs and Silver ETFs track the respective domestic bullion prices on a real-time basis; their units can be bought and sold just like stocks. Each unit of the ETF is equal to 1 gram of gold/silver and is backed by physical gold/silver of very high purity. The benefit of investing in a commodity in ETF form over physical form is that investors are assured of high purity. Furthermore, since the units are held in demat form, investors do not have to worry about theft and storage hassles.

4) International ETFs

International ETFs invest in international stocks, thereby offering investment opportunities beyond the domestic market. They track indices such as S&P 500, Nasdaq 100, NYSE FANG+, etc. which can assist investors in geographical diversification. These funds may track developed and emerging market equities such as the USA, China, Hong Kong, etc.

Table 2: Best ETFs in India based on 3-year returns

Securities quoted are for illustration purpose only and are not recommendatory
Data as of November 24, 2023
(Source: ACE MF, data collated by PersoanalFN) 

How to invest in Exchange-traded Funds?

Since ETFs are traded on stock exchanges (just as stocks), investors mandatorily need a trading and demat account to transact. Once a demat account is opened, investors can begin investing in the units of ETF by selecting the ETF of their choice listed on exchanges and by transferring the investment amount.

The NAVs of ETFs fluctuate throughout the trading session as per the demand and changes in the market value of the scheme’s holdings. The units can be purchased and sold throughout the trading hours at the prevailing real-time NAV. The schemes disclose the closing NAV at the end of the day.

As an investor, prefer ETFs that have lower tracking error compared to similar schemes in the category, which will ensure that the performance of the fund does not deviate much from the index.

What are the advantages of investing in Exchange-traded Funds?

• Diversification — ETFs allow investors to create a diversified portfolio of passive schemes belonging to different asset classes, market cap segments, and geographies.
• Liquidity — Units of ETFs can be bought and sold on exchanges throughout the trading hours at real-time prices. It is noteworthy that some ETFs enjoy better liquidity than others, which makes it easier to find a buyer or seller.
• Transparency — ETFs track a specific index, and therefore, there is transparency about the securities owned by the scheme. Furthermore, ETFs are also required to disclose the closing NAV, just like any other mutual fund scheme.
• Low-cost investment – ETFs, being passively managed funds, entail a much lower expense ratio compared to actively managed mutual fund schemes as they are passively managed.
• Eliminates unsystematic risk — Since ETFs follow a passive investment strategy, i.e. simply follow the underlying benchmark index, the unsystematic risk of the fund manager’s bets going wrong or any potential behavioural bias, gets eliminated.

What are the risks involved in Exchange-traded Funds investment?

Since ETFs invest in various securities, such as equities, bonds, and commodities, they are prone to market volatility. Thus, ETFs cannot be construed as a safe investment option. Depending on the type of scheme, an ETF may be prone to various risks, such as market risk, liquidity risk, currency risk, and sector/commodity-specific risk.

Some schemes may also carry chances of high tracking error. A Tracking error is the deviation of an ETF’s returns from its underlying index. Factors such as the cash balance held by a scheme, the time lag in rebalancing/reshuffling of the portfolio in accordance with the index, dividend payouts, etc., can cause tracking error to rise.

What is the difference between Exchange-traded Funds and actively managed mutual funds?

Exchange-traded Funds and Mutual Funds differ in their functionality and associated risks as follows:

What is the difference between Index Funds and Exchange-traded Funds?

Unlike ETFs, where investors need a trading & Demat account to transact, Index Funds can be bought directly through an AMC or mutual fund distributor, similar to any actively managed mutual fund.

In terms of transactions, all transactions in the case of Index Funds take place based on the closing NAV, whereas ETFs can be purchased and sold at the prevailing real-time NAV.

They also differ in terms of expense ratio as the cost involved is generally slightly higher in the case of Index Funds compared to ETFs. However, it is important to note that the total cost of ownership can be higher when one invests in ETFs, as it can involve additional expenses such as annual charges for trading account, brokerage on transactions, etc.

In the case of Index Funds, it is the responsibility of the mutual fund house to allocate units for purchase transactions and to honour redemption requests. On the other hand, in the case of ETFs, demand (i.e. its trading volume) is an important factor that determines its liquidity. Liquidity is usually higher for ETFs that track popular indices such as the Nifty 50 and S&P BSE Sensex, while it is lower in the case of other indices. Therefore, buying and selling units at a preferred price may not be as convenient for ETFs with lower liquidity.

[Read: Index Funds vs Mutual Funds: Know the Difference]

How are Exchange-traded Funds taxed?

Equity-oriented ETFs — The capital gains on redemption of equity-oriented ETFs are taxed at the rate of 15% if the holding period is less than one year. If the units are redeemed after one year, capital gains are taxed at 10% if the gains exceed Rs 1 lakh in a financial year.

Non-Equity-oriented ETFs — The capital gains on redemption of non-equity-oriented units (Debt ETF, Gold ETF, and International ETF) are taxed as per income tax slab rates applicable to an investor.

How to choose the best Exchange-traded Funds?

Investors can consider the following factors to pick the best ETF:

• Liquidity — ETFs that track popular indices such as the Nifty 50 and S&P BSE Sensex enjoy high liquidity i.e. the ease of buying and selling. Buying and selling units at a preferred price may be challenging if you invest in an ETF with lower liquidity.
• Cost – In the case of two similar ETFs, prefer the one with a lower expense ratio, as it can boost your overall portfolio returns in the long run.
• Tracking error – While picking ETFs for the portfolio, prefer schemes with low tracking error compared to similar schemes in the category. This will ensure that the performance of the fund does not deviate much from the underlying index.

Who should invest in Exchange-traded Funds?

ETFs are suitable for investors looking to build a low-cost mutual fund portfolio by mirroring the performance of a specific index. Investors planning for long-term goals and having a high risk appetite can consider investing in a mix of Equity ETF, International ETF, and Gold ETF. On the other hand, investors with low-to-moderate risk appetite and a short-term to medium-term investment horizon can consider Debt ETFs.

To conclude:

ETFs are a convenient way of passive investing for those who find it challenging to select the right mutual fund schemes from a plethora of actively managed funds available in the market.

ETFs can help investors earn decent returns in the long run; but don’t expect market-beating returns. Investors must ensure that they choose schemes carefully, taking note of its suitability to their investment objectives, risk profile, and investment horizon. Investors should ideally avoid sector/theme-oriented ETFs as they are highly risky.

Depending on one’s financial objectives, investors can determine whether to invest in an actively managed mutual funds, or passive funds such as ETF, or a combination of both.

This article first appeared on PersonalFN here