What are ETFs and How Do They Work?

4 min read

The Indian investment market has undergone a sea change over the last three decades. Investors have confidently moved from the traditional investment instruments like bank fixed deposits, shares, and mutual funds to the more evolved options like derivatives, commodities, and exchange traded funds or ETFs.

An Exchange Traded Fund (ETF) is a portfolio of securities that can be traded on a stock exchange. Hence, with an ETF, you reap the benefits of a diversified portfolio (like in mutual funds) while enjoying the liquidity of being traded on a stock exchange (like stocks).

Evolution of ETFs in India:

ETFs were first created in the early 1990s. After nearly a decade, India saw its first ETF – the Nifty ETF Fund or Nifty BeEs, launched by Benchmark Mutual Fund. This ETF tracked the performance of the Nifty 50 Index. 

The initial acceptance of ETFs was slow, as is the case with any new financial instrument. However, over the years, ETFs have grown in popularity at a steady pace.

Benchmark Mutual Fund continued to be the pioneer of ETFs in India and launched the first debt exchange-traded fund in 2004 called Liquid BeEs (Fixed Income ETF).

In 2007, the fund house launched the first gold exchange-traded fund called Gold BeEs.

And, in March 2014, the Government of India decided to disinvest a part of its holdings in Public Sector Units via ETFs. This led to the launch of the CPSE ETF (Central Public Sector Enterprise Exchange Traded Fund)

Now it is time to deep dive in the world of ETFs!!

Exchange Traded Funds: 

An Exchange Traded Fund (ETF) is a type of investment instrument that is bought and sold on stock exchanges. In terms of the buying/selling procedure as a user, the ETF trade is similar to the trade in stocks. ETFs can have underlying assets like commodities, Bonds, and/or stocks. An exchange traded fund resembles a Mutual Fund in its basket orientation, but unlike a Mutual Fund, ETFs can be sold at any time during the trading session with no cut-off timing for buying or selling.

What Does an ETF Contain? 

ETFs can contain stocks, bonds, commodities, foreign currency, money market instruments, or any other security. Exchange traded funds may also contain index constituents like the S & P 500 (United States), Nifty 50 (India) or any other index/benchmark of any country. An ETF could also possibly contain derivative instruments.

Types of Exchange Traded Funds (ETF):

 There are various types of exchange traded funds with each having different underlying components. 

  1. Index Funds ETF:

An Index ETF is mainly a passive Mutual Fund that allows investors to purchase a pool of securities in a single transaction. The objective here is to track the performance of a stock market index (for e.g. Nifty 50). When an investor purchases a quantity of an index fund or ETF, it means that the investor is purchasing a share of a portfolio that contains the securities of the underlying index. 

2. Gold ETF:

Gold ETFs are instruments that are based on gold prices or invest in gold bullion. Gold exchange-traded funds track the Gold bullion performance. When the gold price moves up, the value of the exchange-traded fund also rises and when the gold price goes down, the ETF loses its value. In India, many Gold ETF Funds are managed by SBI, ICICI, Axis, Reliance ETF Gold BeES, etc. among other ETFs.

3. Bond ETF:

The Bond ETF is very similar to bond mutual funds. Bond exchange traded funds are a portfolio of bonds that trade on an exchange like a stock and they may be passively managed. LIC Nomura MF G-Sec Long Term ETF and SBI ETF 10 year Gilt are some of the bond ETFs available in India. 

4. Sector ETF:

The Sector exchange traded fund invests solely in stocks and securities from a specific sector or industry. Some of the sector-specific ETFs are Pharma funds, Technology funds, etc having underlying assets in these specific sectors. Some sector ETFs currently in India are RShares Dividend Opportunities ETF, RShares Consumption ETF. etc.

5. Currency ETF:

Currency exchange traded funds allow the investor to participate in currency markets without buying a specific currency. This is invested either in a single currency or in a pool of currencies. The idea behind this investment is to track the price movements of a currency or a basket of currencies.

How do ETFs work?

The working of an ETF can be summarized in the following manner – the fund provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors.

 It is important to note that shareholders own a portion of an ETF, but they don’t own the underlying assets in the fund. Even so, investors in an ETF that tracks a stock index may get lumpsum dividend payments (or reinvestments), for the stocks that make up the index. 

While ETFs are designed to track the value of an underlying asset or index — be it a commodity like gold or a basket of stocks; they trade at market-determined prices that usually differ from that asset. 

Unlike regular mutual funds, an ETF trades like a common stock on a stock exchange. The traded price of an ETF changes throughout the day like any other stock, as it is bought and sold on the stock exchange. The trading value of an ETF is based on the net asset value of the underlying stocks that an ETF represents. ETFs typically have higher daily liquidity and lower fees than mutual fund schemes, making them an attractive alternative for individual investors.

How are ETFs taxed?

Index ETFs and sectoral ETFs are treated as equity-oriented schemes for the purpose of taxation. Accordingly, short term capital gains made on ETF units held for less than one year are taxed at 15%. Long term capital gains on units held for more than one year are taxed at 10%, without indexation benefit. Long term capital gains upto ₹1 lakh are not taxed.

Gold ETF and International ETFs are taxed as non-equity funds. Short term gains made on ETF units held for a period of less than 36 months are taxed as per the applicable income tax slab rate. Long term capital gains on units held for over one year are taxed at 20% after indexation benefit.

As already discussed above mutual funds continue to be the pioneers of ETFs, so how are ETFs different from Mutual Funds (MFs) and Hedge Funds, let’s discuss in detail.

Key Difference between ETFs and Mutual Funds

  1. The main difference between an ETF, a MF and a Hedge Fund is that while ETFs can be actively bought and sold on the exchanges, just like any other shares, one can only purchase a unit of a MF from a fund house. On the other hand, Hedge Funds are mostly accessible only by high-net-worth investors.
  1. ETFs generally do not have any minimum lock-in period and can be bought and sold by an investor at their convenience. However, a MF unit usually involves some minimum lock-in, and selling the units before this period can also attract a penalty. Hedge Funds have longer investment periods as compared to mutual funds.
  1. MFs are actively managed by fund managers or professionals, while ETFs are passive investment options that track the performance of an index or broader class of instruments. Hedge Funds are not registered and are open to qualified investors only.
  1. You can start investing in MFs and ETFs with a small sum of money but in the case of Hedge Funds a huge amount of investment is required.

As an investment option, ETFs have evolved as one of the most preferred investment options for investors in a very short span of time. Not only are they diverse, but they are also easy to trade and are more liquid investments.

With ShareIndia, you get to choose the best ETF options that diversify your investment portfolio. ShareIndia offers dependable advice on how to invest and how to diversify your investment modes. To know more on how to grow more; click here.

Disclaimer: Any Advice or information in the post is a general advice for education purpose only and is not responsible for generating any trading profit for anyone, please do not trade or invest based solely on this.

Leave a Reply

Your email address will not be published.