Exchange traded funds (ETFs) are a popular form of passive investing in the world. In India ETF investing is just about catching up. How does an ETF work? The fund AMC that is sponsoring the ETF will invite institutions to subscribe to their ETF portfolio by buying shares reflecting the Nifty (in case of a Nifty ETF). Then this entire corpus created in the same proportion as the Nifty components in the index are converted into small units and sold to retail investors. It is these units that are traded on the stock exchanges..
5 things you need to know about an ETF..
ETFs are broadly available in 4 categories. There are index ETF that are benchmarked to the Nifty or the Sensex. Secondly, there are gold ETFs that are indexed to the market price of gold. Thirdly, there are sectoral or thematic ETFs which are benchmarked to a portfolio of stocks in the particular industry. Lastly, there are international ETFs which invest in funds abroad; these are normally funds sponsored by their parent based in the US/Europe/Japan.
ETFs are listed and traded on the stock exchanges like any other stock. There are buyers and sellers and the price is determined based on the demand and supply. Every ETF will be assigned a unique ISIN number and you can therefore hold these ETFs in your demat account the same way as you hold other shares and securities in your demat account.
What does the ETF sponsor do with the money? When you are invested in gold ETFs, equivalent amount of gold is held in a gold custodian bank. The Bank of Nova Scotia, Canada is one of the most popular gold custodian banks. That means that your gold ETFs are fully backed by physical gold in the vaults of the custodian bank. E-Gold, on the other hand, does not require any vaults.
ETFs have a much lower expense ratio compared to mutual funds. Indian mutual funds have an expense ratio in the range of 2.5%-3.0% whereas an ETF will have an expense ratio of less than 1%. Also, unlike an equity fund or an index fund, the ETFs are traded like stocks between buyers and sellers. The AMC does not have to issue fresh units or redeem units accordingly.
ETFs are useful for diversifying your portfolio. However, there are 3 risks of ETFs you need to be conscious of. Firstly, this is a market product and hence it is subject to the fluctuations of the market. While the trading starts around the indicative NAV, actual prices may fluctuate with the market conditions. Secondly, bid-ask spreads on ETFs could widen adding to your risk. Lastly, there is tracking error risk that your ETF may not precisely reflect the underlying index (in case of index ETFs).
Understanding the ETF investing process flow..
Every ETF will have an indicative NAV around which the ETF will get traded. Depending on market conditions, you can place an order to buy an ETF on your online trading terminal itself. For example gold ETFs trade normally in units of 1 gram so you can buy 1 unit of gold for around Rs.2900. This will fluctuate during the day based on the gold prices. Once you have purchased the ETF, on T+2 day this ETF will get credited into your demat account. When you want to sell the ETFs, you can sell it on your trading interface like any other equity. If it is an offline order you need to ensure that the DIS is deposited on time. Else the entire process of debit to your demat account is real-time. On T+2 day, the proceeds of your sale will be credited to your designated bank account.
Understanding tax implications of ETFs..
There are two sets of implications for ETFs based on their underlying assets. Let us look at them separately..
Tax implications for index ETFs and sectoral ETFs..
For tax purposes index ETFs and sectoral ETFs are treated in exactly the same way as equity funds. That means any gains will be classified as short term capital gains if held for less than 1 year and taxed at 15%. If these ETFs are held beyond 1 year then it becomes long term capital gain and is entirely tax-free in the hands of the investor.
Tax implications for Gold ETFs and International ETFs..
For tax purposes, gold ETFs and international ETFs are treated as non-equity products. That means it will be short term gains if held for less than 3 years and will be taxed at your peak rate applicable. If held for more than 3 years then it will be long term capital gains and will be taxed at 10% of gains or 20% of indexed gains, whichever is lower.
In India it is only gold ETFs that really took off during the sharp spike in gold prices in the 2009-2012 periods. Investors still prefer index funds over index ETFs for passive investing. Obviously, the product needs to mature a lot more and become more liquid before retail investors can get genuinely interested in ETFs.