What are ETFs? A Beginner's Guide to Investing in Exchange-Traded Funds

Unlock investment success with our guide to ETF fund types and benefits. Your key to a prosperous financial future.
3 mins
03 August 2023

In recent years, India's financial markets have witnessed substantial growth and innovation, providing investors with an array of investment options. Among these, Exchange-Traded Funds (ETFs) have emerged as a popular and accessible mutual fund investment option, gaining significant traction among Indian investors.

ETFs have brought a new dimension to the Indian investment landscape, offering benefits that align well with the preferences and requirements of Indian investors.

Understanding ETFs

In India, ETFs function as open-ended investment funds. Underlying units of ETFs are listed and traded on stock exchanges. They pool funds from multiple investors and invest in a diversified portfolio of assets, such as stocks, bonds, or commodities, based on a specific index, commodity or investment strategy. ETFs are structured to track the performance of their underlying indices or assets closely. The units of ETFs are bought and sold on the exchange and the liquidity is facilitated by Authorized Participants (APs).

How ETFs Work

Let's explain the process of creating and redeeming ETF units using an example of a commodity, like gold:

Imagine there's an ETF that tracks the performance of gold prices. To make this ETF work, a special player called the "authorized participant" (AP) comes into the picture. APs are usually big financial institutions or market makers.

Here's how it works:

  1. Creating ETF Units:
    When there is demand for more shares of the gold ETF, the AP steps in. They acquire the actual gold, just like physical gold bars or gold certificates, that will represent the value of t’e ETF's shares. They then deliver this gold to the ETF's manager/ AMC, who takes care of the ETF's assets.
    In return for delivering the gold, the ETF's manager/ AMC creates new units of the ETF. These new units are then transferred to the AP. So, the AP now has units in the ETF that represent a portion of the total gold held by the ETF.
  2. Redeeming ETF Units:
    Now, let's say an investor wants to sell their units of the gold ETF. The AP buys those ETF units from the investor.
    When the investor sells their ETF units, the AP takes those units and redeems them back to the ETF's manager/ AMC. In exchange, the ETF's manager gives the AP the corresponding amount of actual gold, just like the gold bars or certificates or cash that the ETF is holding.

Keeping the ETF's Market Price in Line:

The process of creating and redeeming ETF units is essential for making sure the price of the ETF on the stock exchange stays very close to the actual value of the gold it holds. The Buy and Sell price of ETFs should lie in the close range of its real-time NAV for maintaining product efficiency.

In summary, the creation and redemption mechanism with the help of authorized participants (APs) ensures that the price of the gold ETF on the stock exchange closely reflects the true value of the gold it holds. This way, investors can buy or sell shares of the gold ETF at a price that is fair and transparent, based on the actual value of the underlying commodity - gold.

Types of ETFs in India

Indian investors can choose from a diverse range of ETFs to suit their investment objectives and risk appetites. Some of the common types of ETFs available in the Indian market include:

  1. Index ETFs: These ETFs aim to replicate the performance of a specific stock market index, such as the Nifty 50 or the Sensex. They provide investors with exposure to a broad market segment or a specific sector/ Smart-Beta Strategy.

  2. Gold/ Silver ETFs: Gold/ Silver ETFs allow investors to invest in the price movements of gold/ silver without physically owning the precious metal.

  3. Sectoral ETFs: Sector-specific ETFs enable investors to focus on particular industries or sectors, like banking, technology, or energy, etc.

  4. Bond ETFs: Bond ETFs invest in benchmark indices of fixed-income securities, including government bonds and corporate bonds, catering to investors seeking income and stability.

  5. International ETFs: These ETFs provide investors with exposure to international markets and assets via international Indices (viz. S&P 500, Nasdaq 100, etc) allowing them to diversify globally.

  6. Smart Beta ETFs: These ETFs utilize alternative index construction methodologies, focusing on factors like low volatility, high dividend yield, quality, momentum, Alpha, etc rather than traditional market capitalization-based indices.

  7. Commodity ETFs: These ETFs track the price movements of commodities like oil or precious metals.

Advantages of ETFs for Indian Investors

  1. Affordability: ETFs offer a cost-effective investment solution with relatively lower expense ratios, making them an attractive choice for cost-conscious Indian investors.

  2. Diversification: ETFs provide diversification by investing in a basket of securities, reducing exposure to individual stock risks.

  3. Liquidity: Being listed on stock exchanges, ETFs offer intraday liquidity, allowing investors to buy or sell units at prevailing market prices throughout the trading day.

  4. Taxation: Taxation for ETFs depend on the underlying stock. Index and sectoral ETFs are regarded as equity-oriented ETFs when it comes to tax. As a result, short-term capital gains on ETF units retained for less than a year are taxed at a rate of 15%. Long-term capital gains on units maintained for over a year are levied at a rate of 10%, without the benefit of indexation. Long-term capital gains up to Rs. 1 lakh are exempt from tax.
    Gold ETFs and international ETFs are treated as non-equity funds for taxation purposes. if ETF units are held for less than 36 months, any short-term gains are taxed according to the relevant income tax bracket. Long-term capital gains from units held longer than a year are subject to a 20% tax, considering the indexation benefit.
    A note to be included wherever tax rates are mentioned. The note to state that the tax rates mentioned above are excluding surcharge if any and cess.

  5. Transparency: ETFs regularly disclose their portfolios, NAVs enabling investors to make informed decisions about their investments.

Exchange-Traded Funds (ETFs): Understanding Risks

Exchange-Traded Funds (ETFs), like any other investment assets, come with inherent risks that investors need to be aware of before making investment decisions. Understanding these risks is essential to manage investments prudently and align them with individual financial goals and risk tolerance.

Let's delve into some of the key risks associated with ETF investments in the Indian context:

  1. Market Risk: ETFs are subject to market risk, which refers to the potential losses stemming from overall market movements. If the market experiences a downturn, the value of the underlying assets in the ETF's portfolio can decrease, leading to a decline in the ETF's net asset value (NAV) and market price.
  2. Tracking Error: While ETFs aim to replicate the performance of a specific index or asset, there might be a slight disparity between the ETF's returns and the index it tracks. This difference is known as tracking error and can be influenced by factors such as transaction costs, management fees, and imperfect replication of the index.
  3. Liquidity Risk: Although ETFs are traded on stock exchanges, the liquidity of certain ETFs may vary. In times of market stress or if the underlying assets are illiquid, it may become challenging to buy or sell ETF units at the desired price, potentially resulting in higher bid-ask spreads.
  4. Concentration Risk: Some ETFs are concentrated in specific sectors, industries, or asset classes. If the particular sector or industry faces challenges or a significant event affects the asset class, the ETF's performance could be adversely impacted.
  5. Currency Risk: For ETFs with international exposure, fluctuations in currency exchange rates can affect the returns for Indian investors. Currency risk arises when the investment is denominated in foreign currency, and changes in exchange rates can either enhance or erode investment gains.
  6. Counterparty Risk: Some ETFs use financial derivatives or engage in securities lending to enhance returns. This introduces counterparty risk, which is the risk that the entity on the other side of the transaction might default or fail to fulfil its obligations.
  7. Inherent Risk of Underlying Assets: ETFs invest in a diversified basket of assets, but the risk associated with the underlying assets remains. For instance, equity ETFs may be exposed to risks associated with the individual stocks in the portfolio, while bond ETFs may face interest rate risk and credit risk.
  8. Regulatory and Taxation Risks: Changes in government regulations or tax laws can impact the returns and taxation of ETF investments, potentially affecting the attractiveness of certain ETFs.

Factors to Consider Before Investing in ETFs

  1. Investment Objective: Determine your investment goals, whether it's capital appreciation, income generation, or diversification. Choose an ETF that aligns with your objectives.
  2. Asset Class and Sector: ETFs cover various asset classes and sectors. Assess your risk tolerance and preference for sectors like technology, healthcare, or commodities before investing.
  3. Expense Ratio: Evaluate the ETF's expense ratio, as lower fees can impact your overall returns. Look for cost-efficient options without compromising quality.
  4. Liquidity: Ensure the ETF has sufficient trading volume and liquidity to buy and sell shares without significant price fluctuations.
  5. Historical Performance: Examine the ETF's historical performance and its ability to track its underlying index accurately. Past performance isn't indicative of future results, but it provides insights into the ETF's tracking ability.

Conclusion

While ETFs offer several advantages, it is crucial to recognize and manage the inherent risks associated with these investment vehicles. By adopting a well-informed and balanced approach, investors can leverage the benefits of ETFs while navigating potential risks effectively. Consulting with a financial advisor and conducting thorough due diligence are essential steps to make informed investment decisions and align ETF investments with individual financial goals and risk tolerance.

Discover a wide selection of ETFs with comprehensive analysis for informed investing on the Bajaj Finserv platform.

ETFs provide diversification by investing in various stocks or bonds, effectively reducing overall portfolio risk. Moreover, they are easily accessible, allowing you to buy and sell throughout the trading day. Start your ETF investment journey with us today!
 

Frequently Asked Questions

What are ETFs in simple words?

Exchange-Traded Funds (ETFs) are like baskets of assets, such as stocks, bonds, or commodities, that are traded on stock exchanges, providing investors with diversified exposure to these assets.

What is the best ETF in India?

The "best" ETF depends on your investment goals. Choose based on your objectives and risk tolerance.

Can I sell ETF anytime?

Yes, you can sell ETF shares anytime during market hours when the stock exchange is open. ETFs offer intraday liquidity, so you can trade them throughout the trading session.