Beginners Guide to Investing in ETFs

Published On: 07-May-2019

One may invest in equity markets by following any of the two investment strategies – active investing or passive investing. While active investing requires careful and prudent selection of the stocks in the investment portfolio, passive investing refers to mirroring the benchmark index entirely.

In passive investment products, the fund managers do not have any discretion to invest outside the index constituents or deviate from the index weightage of different index constituents. It helps the investors to eliminate the unsystematic risk from investment plans.

Exchange Traded Funds, commonly referred to as ETFs, are the mutual funds which track the underlying index with an intent to replicate its performance for the investors. So, if the underlying index moves by 15% in a year, an ETF tracking the index will generate similar returns for its investors (less the expenses). As such investing in ETFs allow the investors to have direct investment exposure to popular indices like S&P BSE Sensex, Nifty50, Nifty Next50 etc.

Unsystematic risk refers to the risk of making a wrong selection for the investment portfolio. While the investors can't invest directly in the benchmark indices, an Exchange Traded Fund (ETF) makes it convenient for them to have similar investment exposure.

 

Benefits of Exchange Traded Funds (ETFs)

What Is an Exchange-Traded Fund (ETF)?

ETFs are such securities which aim to track an underlying index through passive investment strategy. ETF units are tradable on stock exchanges like equity shares, etc. and their investment portfolio replicates the composition of such underlying index. So, if the underlying index moves by 15% in a year, an ETF tracking the index will generate similar returns for its investors (less scheme expenses).

Types of ETFs

ETFs can be broadly categorised into three categories depending upon the asset class they are tracking:

Equity ETFs

Equity ETFs may track different benchmark equity indices, including but not limited to NSE Nifty 50, S&P BSE Sensex, Nifty Midcap100, etc. Such ETFs may also track international equity indices like NASDAQ, Hang Seng etc. thereby providing a convenient investment option to invest overseas.

Debt ETFs

Debt ETFs track indices comprising of debt securities like PSU Bonds, SDL Index etc.

Commodity ETFs

Commodity ETFs track the prices of physical commodities, like Gold ETF etc.

Why invest in ETFs?

Investing in ETFs allow the investors to have direct investment exposure to popular indices like S&P BSE Sensex, Nifty50, Nifty Next50 etc. Another important feature of an ETF is that the fund managers don’t have the flexibility to go beyond the index securities or deviate from the weightages. Given the limited role of fund managers in managing passive funds, such schemes carry low fund management changes. This results in the Total Expense Ratio (TER) of ETFs to be lower, thereby providing a cost-efficient investment option to the investors.

How do Exchange Traded Funds (ETFs) Work?

ETFs are just like other mutual funds , the only difference being in the investment strategy. While actively managed mutual funds are managed through active investment strategy with fund managers taking the investment decisions, ETFs track a specific underlying index. Here is how an ETF typically works:

  1. Creation of ETF Units – The mutual fund creates ETF units with securities in the same weights as the underlying index. These units are listed on stock exchanges for buying and selling by the investors.
  2. Trading of ETF Units through Stock Exchanges - You may invest in ETF units by putting buy/ sell orders for ETF units through the stock trading account. The units will be credited/debited to/from your Demat account, just like normal stocks.
  3. Valuation Changes of ETF Units – Since the underlying investments for the ETF units is the investment portfolio tracking the underlying index, any changes in the value of the investment portfolio will drive the changes in the NAV of the ETF units. However, there may be some variation due to demand and supply of ETF units on exchange, etc.

ETF Benefits for investors include the following

1. Lower costs

Since the ETFs are passively managed, the investment and fund management team only need to track the underlying index and implement the changes whenever they happen. There is no flexibility with the fund manager to deviate from the index weight, then that of the underlying index. Therefore, ETFs tend to have lower expense ratios than actively managed funds.

2. Elimination of unsystematic risk

The investment risk is classified into two categories – systematic risk and unsystematic risk. Systematic risk refers to the broader market risks, which is the risk of movements in the equity markets due to changes in the macroeconomic environment.

On the other hand, unsystematic risks are the risks which are specific to the specific investment option, i.e., the select mutual fund scheme . ETFs only carry the systematic risk, since they replicate the market indices and to some extent, the risk of tracking error, which means the time gap between the time changes are implemented in indices and when the changes are made effective in ETF portfolio. As such, investors may use ETFs to eliminate unsystematic risk in their portfolio effectively.

3. Diversification

Since the underlying indices are constructed after adequate research and back-testing of data, they encapsulate different market sectors and segments within the same index. Investing in ETFs provide the same diversification across the market segments to the investors.

4. Liquidity

Since the ETF units are listed on the recognised stock exchanges, the investors may liquidate their investments at any point of time during the exchange trading hours.

Disadvantages of ETF

While ETFs are preferred investment options with passive investing strategy, here are the disadvantages of ETFs:

Liquidity

Investors can undertake transactions in ETFs only through stock exchanges. As such, the transactions are contingent on the sufficient market depth for such orders on stock exchanges. In case there are not enough sellers for the ETF units at a given price, one may not be able to buy ETF units at prevailing price. Similarly, if one needs to liquidate their ETF investments but there are no buyers for ETF units at the market price, one will not be able to liquidate their investments.

No alpha generation

Fund managers for ETFs are only required to track the investment portfolio to replicate the composition of the underlying index. The investment portfolio will always mirror the underlying index. As such, the ETF returns will emulate the returns generated by the underlying index.

The fund cannot outperform the benchmark index, and thus, there will be no alpha generation for the investors. However, ETFs can still be considered by the investors who rely on the broader market wisdom and are content with the benchmark returns.

Can be held only in Demat

ETFs can be held only in Demat accounts, and one cannot invest in ETF units through mutual fund house or through physical submission of the application form for investor folio. Owing to these inherent limitations, not all investors are inclined to invest into ETFs.

How to Invest in ETF?

ETFs are listed on a stock exchange, and thus, they may be traded in the same way as an equity share. The investors may buy/ sell ETF through their Demat trading accounts by placing a bid for purchasing the units at market price or the limit price. A limit price order gets executed if the market price of the ETF units touches or goes below the limit price. Further, such units may be held by the investors only in their Demat accounts.

ETFs vs Index Funds

While both the ETFs as well as index funds are passive investment products, here is a brief comparison between the two:

 

   Features

  ETFs

   Index Funds

Market Price / Net Asset Value (NAV)

Available real-time at stock exchange platforms

Calculated by the mutual fund house at the end of the day

Transaction undertaken through

Stock Exchanges

Mutual Fund

Portfolio Disclosure

Daily

Monthly

Holding

Compulsorily in Demat form

Physical + Demat

Liquidity Depends upon market depth of buy/ sell orders at stock exchanges Assured through mutual fund house
 

Taxation of ETFs

The taxation of ETF units is dependent upon the underlying index. If the underlying index is an equity index, the taxation will be in line with the tax treatment for equity shares, where any short-term gains (with an investment period of less than 12 months) are taxed at 15% (plus applicable cess and surcharge) and the long-term capital gains are taxed at 10%. Such long-term capital gains are also exempt up to Rs. 1 lakh a year and only gains beyond Rs. 1 lakh are taxable.

In case the ETFs are tracking a debt index, like SDL Index, etc., the specified cut-off period for classification as LTCG and STCG is 36 months. If the investment has been held for less than 36 months, the gains are classified as STCG and taxed at the regular tax rates applicable to the investor. However, in case of mutual fund units have been held for 36 months or more, LTCG on such debt fund units is taxed at 20% (plus applicable cess and surcharge) with benefit of indexation.

Considering the transparency embedded within the ETF as an investment product and its lower cost of investing, ETFs mays be considered by the investors who are willing to stay content with the broader market indices’ returns and are not running for the alpha-generating mutual fund schemes.

How to Buy and Sell ETFs

ETFs are listed on a stock exchange, and thus, they may be traded in the same way as an equity share. One can invest or sell ETFs in the same manner as they are doing it for stocks. To invest in ETFs, one needs to place a buy order on the stock exchange through the Demat trading account. The order must specify the quantity of ETF units being offered to buy/ sell and the price at which the investor is offering to buy or sell.

As such, the order may be a market order or limit order. A market order means that the order would be executed at whatever the prevailing market price is. In contrast, a limit order specifies the maximum buying/ minimum selling price at which the investor is willing to buy or sell the ETF units.

In case the market price reaches the specified limit price, the order is executed. However, if the specified limit price is not touched, the order is cancelled at day end and the investor will need to place another order on the next trading day if required. Further, such units may be held by the investors only in their Demat accounts.

ETF Need to be more vigilant about process and revise the existing process in conjunction with the compliance teams and create more content for general awareness of passive offerings creation and redemption.

At the time of initial NFO ( New Fund Offer ) for ETF, the money invested by the investors is pooled and an investment portfolio is created which mirrors the composition of the underlying index. The entire investment is bifurcated in ETF units with face value of Rs. 10 each. Once such ETF units are listed post initial allotment, the NAV of the ETF units changes every day. Further, the demand and supply of such ETF units on stock exchanges also determine the real trading price of such units.

When an investor places an order for ETF units on stock exchanges, the ETF units only change hands from one investor to another and there is no change in the overall ETF portfolio. However, sometimes mutual funds act as market makers for the ETF units. As such, they create fresh ETF units at the NAV and provide supply of such ETF units on stock exchanges for the investors to buy.

Similarly, the mutual funds may buy the ETF units on stock exchange in case of higher supply of such units and extinguish such units at NAV. Both of these actions by the mutual fund houses do not otherwise impact the existing investors but just aim to balance the demand- supply of such ETF units on stock exchanges.

Gold ETF vs Gold Funds

An ETF tracking the gold prices in international market is called Gold ETF, while an index fund tracking the commodity is called Gold fund. While the common link between Gold ETF and Gold Funds is that both these are passive investment options, the differences between ETF and Index funds as discussed in the above paragraphs are equally applicable for Gold ETFs and Gold funds.

How to find the right ETFs for your portfolio

Underlying Benchmark

While one may consider all ETFs to be equal being passive investment options, the underlying benchmark being tracked might make a lot of difference. An ETF may track a large cap index like NSE Nifty50, or a small cap index like CNX Small cap 100 or debt indices like SDL index, etc.

All the indices carry the respective risk-reward trade-offs and remain suitable for investors with different risk appetites. One should choose the right index benchmark before zeroing on the right ETF tracking that index.

Average Daily Turnover

Once the investor has selected the suitable index benchmark, one should then review the average daily turnover of different ETFs tracking that index. The liquidity of ETF units on stock exchanges is crucial parameter for an investor, since in absence of sufficient daily turnover, an investor may not be able to buy or sell the ETF units at the market prices and forced to trade at off-market rates to generate sufficient demand. This difference between the market value and the transaction value is referred to as the impact cost.

Total Expense Ratio (TER)

Since scheme expenses is charged to the ETF returns, a higher expense ratio directly impacts the investor returns. As such, in case of two ETFs tracking same benchmark index, the returns of the fund with higher TER will be lower. Thus, one should prefer investing in ETF with lower TER.

Final word

ETFs thus emerge as an attractive investment option for the investors who seek investment exposure towards the benchmark indices, instead of relying upon the fund managers' selection of stocks. As such, investor may consider investing in ETFs for emulating the returns generated by the underlying indices in a cost-effective manner. Additionally, it is convenient to invest in ETFs sitting at the comfort of home, as the investments must be done online through stock exchanges.

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