ETFs are generally passive funds. Like an active fund, the fund manager does not decide which shares or bonds to choose in an index fund or index ETF, rather the investment of the ETF is only in those shares or bonds on which the index is based.
Although exchange traded funds like ETFs are not yet very popular in India, but gradually the awareness about them is increasing among investors. Mutual fund houses are also now launching ETFs of different categories. Exchange traded funds are similar to mutual funds as they invest the money collected from investors in a portfolio of equities, bonds or gold etc. depending on the objective of the scheme. The specialty of ETFs is that they are listed on an exchange and can be bought or sold like an equity share. ETFs are extremely popular among investors in developed countries.
What are ETFs?
ETFs are generally passive funds. Unlike an active fund, the fund manager does not decide which shares or bonds to choose in an index fund or index ETF, rather the ETF invests in only those shares or bonds on which the index is based. Like mutual funds, ETFs also have different categories like equity, bond, liquid or gold ETFs depending on the objective of the scheme. Equity ETFs can be based on a particular index such as Nifty 50, Nifty Next 50, Nifty Bank or Sensex. Another feature of ETF is that its value changes several times a day because trading takes place in it and the price of ETF keeps increasing and decreasing according to supply and demand. Whereas the NAV of a mutual fund is based on the market closing price. This NAV is decided only once a day.
The value of ETFs changes in real time so investors can take advantage of market fluctuations when investing in or selling ETFs. ETFs are no longer limited to just large caps based on Nifty and Sensex but there are also options for ETFs based on sectoral indices such as Nifty Bank, Nifty IT, Nifty Private Bank, Nifty PSU Bank etc. Apart from equity ETFs, gold ETFs are also available in the market which invest in pure gold and investors get capital gains according to the performance of gold. Bond ETFs provide investors the opportunity to invest in government and non-government bonds. For investors who want to invest in international companies like Amazon, Apple, and Microsoft, there is an option of ETF based on international index.
Comparison with mutual funds
An ETF is based on a single index and the fund manager cannot make any changes to it. Therefore their performance remains almost equal to their benchmark. The expense ratio in ETFs is much lower than any active mutual fund and while investing in ETFs, an investor does not need to look at its past performance like any mutual fund scheme. In a mutual fund, the fund manager tries to ensure that the performance of the mutual fund actively managed by him remains better than the benchmark of the scheme. The fund manager includes and sells shares in the portfolio at his discretion and even has the freedom to decide their ratio. It has often been seen that the top funds in the large cap category have performed better than index funds or ETFs in the long run. To invest in ETF, it is necessary to have a demat account but it is very easy to invest in it.
Income tax liability
Investors may have to pay capital gains tax on the capital gains they make when they sell ETFs. Capital gains tax is different for equity and other capital assets. Investments in equity ETFs for a period of one year or less are considered short term and the capital gain on it is subject to short term capital gains tax of 15 percent. If you sell the investment after one year, it is subject to long term capital gains tax. Long term capital gains tax is not levied on capital gains of Rs 1 lakh and 10 per cent is levied on the amount above that. If you are investing in bond ETF or gold ETF, then the period of 3 years or less will be called short term and the period of more than 3 years will be called long term. In such a situation, the tax on short term capital gains is determined on the basis of slab which can go up to 30 percent whereas on long term capital gains, tax is imposed at 20 percent with the benefit of indexation. Keep in mind that a health and education cess of 4 percent is also levied on the tax amount.
Who is it suitable for?
ETFs are suitable for investors who have limited knowledge of the capital markets and even mutual funds but want to invest in the capital markets with less risk. On the other hand, there are investors who have a good understanding of the capital market and at some point of time they feel that a sector like banking, IT etc. will show better performance than the average capital market as per the current situation, but they are not able to understand this. As to which bank's shares to buy or which IT company's shares to invest in, then one can benefit from this by investing in a sectoral ETF like Nifty Bank or Nifty IT.
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