Introduction

An exchange-traded fund (ETF) is a collection of securities, such as stocks or bonds, that tracks an index and trades on exchanges like an ETF stock. ETFs provide diversification, flexibility, and low fees, making them popular for wealth generation. However, entering the ETF space with no clear plan on getting involved can lead to expensive errors. To help you make better decisions when trading ETFs, here are five mistakes to avoid within India's ETF framework so that you can align your investing with your goals.

1. Having No Idea What Your ETF Tracks

The Error

You probably invest in an ETF based on a tip or because it has performed well. Plus, you probably think ETFs are all the same. Each ETF tracking an index, such as the Nifty 50 or a sectoral index, has a different risk profile.

Problem

If you purchase an ETF without knowing which index it tracks, you could end up in a volatile sector-specific index fund rather than a broadly based market. There are international ETFs that will contain currency risks or, conversely, lower volatility but arguably limited upside potential in growing economies.

How to Avoid It

Before investing, read the ETF's factsheet. Verify what index it tracks, its sector or geographical exposure, and whether it is market-cap focused or theme-based. Then, visit an exchange website and compare the ETFs against each other for risk appetite.

2. Ignoring Liquidity Issues

The Error

Not all ETFs in India trade regularly. You might purchase an ETF stock without checking its buying or selling volume, assuming it will be easy to buy or sell.

Problem

Low-volume ETFs typically have wider bid-ask spreads, meaning you'd pay more to buy and get less when selling. These ETF trading charges, including spreads, quietly erode your returns.

How to Avoid It

Always check the ETF's daily trading volume on the exchange. Opt for funds with tight bid-ask spreads. Use limit orders to control pricing and trade only during major hours (10:30 a.m.—2:00 p.m.) to improve liquidity.

3. Not Considering Tracking Error and Fees

The Error

You think every ETF correlates flawlessly to the index and has minimal expense. However, tracking errors and commissions on ETF trades (expense ratio) can erode your performance.

Problem

When your ETF tracks an index with a substantial tracking error, its returns will deviate from the index. Even if the ETF tracks the index, your returns could decline due to a high expense ratio. Tracking errors can occur in smaller ETFs or ETFs with low assets under management (AUM).

How to Avoid

Track various ETFS of similar indexes to check the differences in tracking error. When selecting an ETF, consider the expense ratio and look for ETFs with a higher AUM to reduce errors and costs. Once you choose ETF funds to track, visit the exchange site or institutional and mutual fund site to confirm the trackers' performance against other ETFs or mutual funds, providing you with confidence in the ETF selected.

4. Ignoring Tax Consequences

The Error

You may not recognise that tax rules apply to an ETF based on whether it's an equity or debt-based investment, and the amount of time you hold it. FIFO applies to each folio of mutual fund ETFs. FIFO does not automatically combine across folios for multiple folios of the same ETF. This clarification is required to report accurate results.

Problem

It could cost you significantly if you misclassify an ETF as an equity-based investment when it is a debt-based investment. Long-Term Capital Gains (LTCG) on equity ETFs of more than ₹1 lakh is charged at 10%, after ₹1 lakh is exempted. Short-Term Capital Gains (STCG), applicable for investments held for 12 months or less, is charged at 15% (not 20%). Debt-based ETFs are taxed at your slab tax rate.

How To Avoid

Ensure that the ETF you buy is appropriately classified as equity-based or debt-based. Hold it long enough to create a Long-Term Capital Gains tax scenario. Factor taxes into your general return expectations and consult a tax advisor for Long-Term Capital Gains reporting based on FIFO in your income tax return.

5. Trading Against a Plan

The Error

ETFs provide a great degree of flexibility, which can tempt you to trade the investment far more often than you would if it were a mutual fund, all without having a clear plan. Emotional trading and trading without a plan can create a lot of anxiety, making dealing with ETFs feel like gambling.

Problem

Although it can be exciting to trade often, your ETF incurs trading costs that will cut into your bottom line every time you trade. Every time you buy, you have trading costs (commissions, taxes, and stamp duties), and you risk buying high and selling low.

How to Avoid It

Utilise ETFs for long-term strategies, such as building wealth or saving for retirement. If you are trading in the short term, use either technical or fundamental analysis. If you want to be more methodical and disciplined in your ETF investment, consider a Systematic Investment Plan (SIP). Always consider transaction costs before executing the trade.

Conclusion

You can boost and diversify your portfolio using ETFs. They could provide you with cheap access to India's markets and more. ETF investing is a great investment option, but it has some pitfalls to avoid. Avoid common pitfalls in ETF investing by knowing the index of the ETF, paying attention to liquidity, tracking error and fees, being tax efficient and having an investment plan for your ETF. If you avoid the pitfalls, you can take advantage of the unique features of ETFs for long-term wealth creation, slow & steady returns. Regardless of whether you increase your return, before your next trade, review your ETF index, and determine how it fits into your goal. Once you know your ETF strategy, the journey can be fruitful with knowledge and discipline.

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