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11 Sep, 2024
6 mins read
Exchange Traded Funds (ETFs) are making waves in the Indian stock markets, contributing about 13% (approximately Rs. 6.95 lakh crores) of the total mutual fund segment, which stands at Rs. 53.40 lakh crores as of March 2024. But what makes them so popular, and why are they favoured over traditional mutual funds by specific investor segments? Dive into this blog to learn what Exchange Traded Funds (ETFs) are in stock markets and how they work for informed decision-making.
Exchange Traded Funds are a basket of securities like mutual funds that can be traded on recognised stock exchanges like stocks. These funds track a benchmark index and hold assets in the same combination and proportion as the benchmark index.
ETFs combine the best features of mutual funds and individual stocks. They offer the diversification and professional management of mutual funds while providing flexibility and real-time stock pricing. This makes them an attractive option for investors looking for a cost-effective and convenient way to invest in the stock market.
An ETF holds a collection of assets like stocks, bonds, or commodities. It can be designed to track a specific index (e.g., Nifty 50, Bank Nifty), sector, commodity, or other asset. ETFs are bought and sold on stock exchanges during the trading day at market prices, similar to regular stocks. You need a Demat account to transact in ETFs.
Investing in ETFs (Exchange-Traded Funds) offers liquidity, diversification, and lower fees than mutual funds. ETFs can be passively or actively managed, providing exposure to a broad range of assets. They also allow investors to receive dividends and interest from the assets held by the ETF.
As mentioned above, ETFs are pools of investments in different classes of securities. Hence, ETFs can be classified based on these asset classes. Here is a list of various types of ETFs available for investment.
Equity ETFs invest in a collection of stocks, typically designed to track a specific index like the Nifty 50 or Sensex. This allows the investors to hold exposure to the entire index without holding all individual stocks. Equity ETFs are one of the most popular ETFs in Indian markets.
Ex: SBI Nifty 50 ETF, UTI BSE Sensex ETF, ICICI Pru Nifty Next 50 ETF, etc
Bond ETFs are ETFs that invest in a range of bonds, such as government, corporate, or municipal bonds. These ETFs track debt indices and are ideal for investors seeking regular income with lower risk than equities. Bond ETFs provide diversification within the bond market and can help stabilise a portfolio by offering more predictable returns.
Ex: Bharat Bond ETF, CPSE ETF, etc
Thematic ETFs focus on themes or sectors such as renewable energy, artificial intelligence, infrastructure, technology, healthcare, or finance. These ETFs allow investors to capitalise on emerging trends and industries expected to grow significantly. Thematic ETFs are suitable for those looking to invest in future growth areas or target particular areas of the economy that they believe will perform well.
Ex: HDFC Nifty Growth Sectors 15 ETF, Tata Nifty India Digital ETF, etc.
Smart Beta ETFs use a rules-based approach to select stocks based on factors like value, momentum, or low volatility rather than just market capitalisation. These ETFs aim to outperform traditional market-cap-weighted indices by focusing on specific investment strategies. Smart Beta ETFs suit investors seeking better returns with a strategic approach.
Ex: Kotak Nifty 50 Value 20 ETF, ICICI Pru Nifty 100 Low Volatility ETF, etc
Commodity ETFs invest in physical commodities like gold, silver, or oil. Gold ETFs are particularly popular as they offer a way to invest in gold without physically owning it. These ETFs track the price of the underlying commodity, providing an easy way to gain exposure to commodity markets and hedge against inflation.
Ex: ICICI Pru Commodities ETF
Leveraged ETFs aim to amplify the returns of an underlying index, providing higher gains (or losses) over short periods. Inverse ETFs aim to deliver the opposite performance of an index, allowing investors to profit from market declines. These ETFs are more complex and suitable for experienced investors looking to take advantage of market movements over short time frames.
International ETFs invest in stocks or bonds from markets outside India. They provide Indian investors with the opportunity to diversify their portfolios globally, gaining exposure to international markets and economies. This can reduce risk by spreading investments across different regions.
Ex: Mirae Asset Hang Seng TEch ETF, Motilal Oswal NASDAQ 100 ETF, etc
Exchange Traded Funds are widely popular investment options for diverse categories of investors. However, to make an informed investment decision, it is important to understand the various advantages and disadvantages of investing in ETFs. Given below is a brief analysis of the same.
The key advantages of ETFs include,
Ease of Trading: ETFs can be bought and sold using a Demat account, making them accessible to retail and institutional investors.
Liquidity: ETFs can be easily bought and sold on stock exchanges throughout the trading day, offering flexibility and quick access to funds.
Diversification: ETFs offer exposure to a broad range of assets, reducing risk by spreading investments across multiple stocks, bonds, or commodities.
Lower Costs: ETFs generally have lower expense ratios compared to mutual funds, making them a cost-effective investment option.
Transparency: ETFs disclose their holdings daily, allowing investors to see what assets they own and how the fund performs.
The key disadvantages of ETFs include,
Tracking Errors: ETFs are prone to tracking errors, meaning they may not perfectly track their underlying index. This may result in the ETF's returns being slightly different from the index it aims to replicate.
Trading Costs: Although ETFs have lower expense ratios, investors may incur brokerage fees each time they buy or sell ETF shares, which can add up over time.
Liquidity Issues: While most ETFs are highly liquid, some niche or less popular ETFs may have lower trading volumes, making it difficult to buy or sell them at desired prices.
Market Risk: ETFs are subject to market fluctuations, and their value can go down if the underlying assets perform poorly.
Complexity: Some ETFs, especially leveraged and inverse ETFs, can be complex and may only be suitable for some investors, requiring a good understanding of their mechanics and risks.
ETFs offer investors a versatile and cost-effective way to diversify their portfolios with a broad range of assets, including stocks, bonds, and commodities. While ETFs provide many advantages, like ease of trading and liquidity of assets, they also have disadvantages, like market risks, tracking errors, and potential tracking errors. Therefore, understanding the benefits and limitations of ETFs can help investors make informed decisions and shape a profitable investment portfolio.
A popular example of an ETF is the SBI Sensex ETF, which tracks the Sensex and allows investors to gain exposure to the top 30 companies listed on the Bombay Stock Exchange (BSE) with a single investment.
ETFs are generally considered safe due to their diversification and lower costs but carry market risks like any investment.
ETFs are not tax-free and are subject to capital gains tax. Short-term gains are taxed at 20%, while long-term gains above Rs. 1,25,000 are taxed at 12.5% without indexation benefit. Debt ETFs, on the other hand, will be taxed as short-term gains irrespective of the holding period and will be taxed as per the applicable slab rates.
ETFs can be better than mutual funds for investors seeking lower costs and greater trading flexibility. However, mutual funds might be more suitable for those who prefer active management and automatic dividend reinvestment
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