Equity class is probably considered the favourite investment class because it can generate multi-bagger returns for its investors. The high return comes with high risk, although the risk can be minimised by investing in a diversified portfolio of stocks. One way of investing in the diversified portfolio class is through the ETF. It helps us in reducing the risk of direct stock investing.
An Exchange Traded Fund (ETF) is an investment fund that is traded on an exchange, just like stocks. ETFs have features of both stocks and mutual funds. ETFs typically track an index, such as the NIFTY 50, BSE SENSEX, and can include a variety of assets, such as stocks, bonds, commodities, and currencies. ETFs offer investors exposure to a broad range of assets, which can provide diversification benefits, and often have lower fees than traditional mutual funds.
Actively vs Passively managed ETFs
Actively managed ETFs are ETFs that are managed by a portfolio manager or team of managers. This means that the portfolio manager or team of managers will choose what investments to make and when. They do this in an effort to generate higher returns than the market(index).
Passively managed ETFs, on the other hand, are ETFs that track a pre-determined index. This means that the portfolio manager will not actively manage the ETF and instead, the ETF will simply follow the index that it tracks. This means that the ETF will have similar returns to the index it is tracking.
The main difference between the two is that actively managed ETFs try to generate higher returns than the market, while passively managed ETFs simply track an index.
In active ETFs, the fund manager uses his or her expertise to generate an extra return, so the expense is on the higher side compared to passive ETFs, where there is no active involvement required.
Type of ETFs
1. Equity ETFs: These ETFs are composed of stocks and are designed to track a particular stock index, such as the BSE Sensex, NIFTY Fifty.
2. Bond ETFs: These ETFs track a particular bond index and are composed of bonds issued by governments and corporations.
3. Commodity ETFs: These ETFs are composed of commodities such as gold, silver, oil, and other natural resources.
4. Currency ETFs: These ETFs track currency pairs, such as the US dollar and the euro.
5. Real Estate ETFs: These ETFs track real estate-related investments such as REITs.
Taxes on ETFs
Capital gains can be short-term and long term and it is different for each of them. In the case of ETFs, it also depends on the type of ETF.
For Equity ETFs
Equity ETFs in India are subject to the same taxes as other Equity investments such as stocks and mutual funds.
Capital Gains Tax: When you sell an ETF, you may be subject to a capital gains tax. Long-term capital gains tax (LTCG) on ETFs held for more than 12 months are taxed at 10% without indexation, on your capital gains for the year which exceed Rs. 1 lakh. Short-term capital gains tax (STCG) on ETFs held for less than 12 months are taxed at 15%.
For Gold, Debt and other ETFs
Taxes for Gold, Debt and other ETFs(Except equity ETFs) in India is the same.
Long-term capital gains tax (LTCG) on ETFs held for more than 36 months are taxed at 20% along with indexation benefits
Short-term capital gains (STCG) on ETFs held for less than 36 months are added to the investor’s income and taxed according to their income slab.
Advantages
Diversification/Accessibility: ETFs provide exposure to a basket of assets (such as stocks, bonds, and commodities) within a single investment. This diversification helps spread risk, reducing the impact of a decline in any one asset.
Liquidity: ETFs are traded on stock exchanges, just like individual stocks. This means they can be bought and sold throughout the trading day at market prices, providing high liquidity for investors.
Lower Costs: ETFs typically have lower expense ratios compared to actively managed funds. This is because they aim to replicate the performance of an index rather than rely on active management, which can lead to lower fees for investors.
Intraday Trading: ETFs can be bought or sold during trading hours at market prices, providing investors with flexibility to trade in ETFs. This contrasts with mutual funds, which are priced at the end of the trading day.
Disadvantages
Limited Active Management: Most ETFs are designed to track a specific index, which means they are passively managed. This can be a disadvantage for investors who prefer active management and believe that skilled fund managers can outperform the market.
Brokerage Fees: Investors who trade ETFs may incur brokerage fees, which can add to the overall cost of investing. Frequent trading can accumulate significant transaction costs over time.
Sector Concentration: Some ETFs may be heavily concentrated in a specific sector/industry eg commodity(Metal). If that sector experiences a downturn, the ETF’s performance may be negatively impacted.
Key Takeaways
- Exchange-traded funds ( ETFs) represent baskets of securities traded on an exchange like stocks.
- Expenses of the ETFs are on the lower side if compared with the category mutual funds.
- The cost of actively managed ETFs is on the higher side if we compare it to passively managed ETFs.
- Taxes on equity ETFs is similar to other equity-linked instruments.
Words of Wisdom
“Debt is like any other trap, easy enough to get into, but hard enough to get out of.” ― Josh Billings
Conclusion
In conclusion, Exchange-Traded Funds (ETFs) have revolutionized the investment landscape by offering a versatile and cost-effective way to access a wide range of asset classes. Their transparency, liquidity, and low expense ratios make them an attractive option for both novice and experienced investors.
