A Beginner's Guide To Investing In India's Top Etfs

Exchange-Traded Funds (ETFs) are a type of investment fund that combines the benefits of diversification offered by mutual funds with the ease of trading equities. ETFs are traded on the stock exchange and are passively managed, aiming to replicate the performance of a benchmark index rather than outperform it. The first ETF in India, Nifty BeEs, was launched in 2002, and since then, ETFs have grown in popularity. They offer investors a cost-efficient way to gain exposure to a diverse range of securities, providing a simple and flexible investment option. This introduction aims to provide an overview of ETFs in India, their advantages, and the process of investing in them.

ETFs vs. Stocks vs. Mutual Funds

Exchange-Traded Funds (ETFs) are a collection of investments such as stocks or bonds that combine the diversification benefits of mutual funds with the ease of trading equities. ETFs are traded on the stock exchange, whereas regular mutual funds are not. ETFs are passive mutual funds that usually track benchmark indices like Nifty or Sensex. The fund managers of ETFs buy stocks of the benchmark indices and ensure that the returns of the ETFs closely match the index returns.

Stocks are small pieces of individual companies, representing a bit of ownership in the company. Stocks are traded on exchanges and are a liquid investment, meaning they can be bought or sold at any time during open market hours. Stocks also come with advanced trading options like stop-loss and trailing-loss orders, which are not available with mutual funds. Stocks are also a more tax-efficient investment vehicle, as capital gains taxes are only incurred when shares are sold, unlike mutual funds, which can generate capital gains throughout the shareholder's time as an investor.

Mutual funds are groups of stocks, offering investors better diversification than individual stocks. Mutual funds are actively managed by fund managers who decide how to allocate assets, whereas ETFs are usually passively managed, tracking market indices or sector sub-indices. Mutual funds are purchased directly from the fund provider, whereas ETFs can be traded between investors. Mutual funds are also purchased at the end of the trading day, based on the net asset value, whereas ETFs can be traded throughout the day, like stocks.

ETFs are a good choice for investors who want the diversification benefits of mutual funds, but with the ease and flexibility of trading stocks. ETFs are also more tax-efficient than mutual funds and have lower fees. However, stocks are a riskier option, as their performance depends entirely on the company, whereas mutual funds and ETFs offer more diversification.

How to Select an ETF

When selecting an Exchange-Traded Fund (ETF), there are a few key considerations to keep in mind. Firstly, ETFs are available in various categories, including equity, gold, international exposure, and debt. Choose the category that aligns with your investment goals and risk tolerance. Each category will have sub-categories to consider as well. For instance, if you opt for an equity ETF, the sub-categories will depend on capitalization and sectors.

Liquidity is another crucial factor. While most ETFs today have sufficient liquidity, making buying and selling units relatively straightforward, some ETFs have lower trading volumes, which can make it challenging to buy or sell units. Therefore, it is prudent to opt for an ETF with a good trading volume.

The expense ratio is an important aspect to factor in, as it can impact your returns. Compare the expense ratios of different ETFs and opt for one with a lower ratio than its peers.

ETFs are designed to track a specific index, and as a result, there may be a discrepancy between the index's returns and the ETF's returns, known as a tracking error. When selecting an ETF, opt for one with a minimal tracking error to ensure its performance closely aligns with the index it tracks.

Additionally, consider the trading costs associated with the ETF. Buying and selling ETFs may incur brokerage fees and other transaction costs, so it's essential to factor these into your decision.

Lastly, ETFs are passively managed, meaning they aim to replicate the performance of the index they track rather than outperform it. This passive management style brings advantages, including lower administrative costs compared to actively managed funds.

Types of ETFs

There are several types of ETFs available in India, which can be classified based on the underlying asset held in the portfolio. Here are some of the most common types of ETFs:

Equity ETFs

Equity ETFs are currently the most popular type of ETF in India. They generally track the Nifty 50 index and its variants. Equity ETFs are traded on stock markets throughout the trading day, and prices are determined by market movements. There is no minimum investment amount, and investors can benefit from intraday market movements. Examples of equity ETFs include DSP Nifty 50 ETF, ICICI Pru Nifty 100 ETF, and Motilal Oswal Midcap 100 ETF.

Bond ETFs

Bond ETFs are designed to provide exposure to fixed-income instruments such as debentures and government bonds with various maturities. They combine the benefits of debt investments with the flexibility of stock investments and the simplicity of mutual funds. Bond ETFs are traded in open cash markets throughout the day on stock exchanges. Examples of bond ETFs in India include government securities (G-Secs) and the Nifty Bharat Bond.

Commodity ETFs

Commodity ETFs available in India include gold and silver ETFs, which try to replicate their respective bullion markets. Gold ETFs provide investors with the opportunity to invest in precious metals in a digital format instead of physical gold. The price of a gold ETF is based on the real-time market price of gold. Gold ETFs are taxed similarly to physical gold, with short-term capital gains tax levied on sales within three years of purchase, and long-term capital gains tax on sales beyond three years. Silver ETFs, such as those offered by Nippon India, ICICI Prudential, and Aditya Birla, are also good options for portfolio diversification.

Sectoral/Thematic ETFs

Sectoral or thematic ETFs are designed to replicate the performance of a specific sector. Examples include the Kotak IT ETF, which focuses on the information technology sector, and the Axis Banking ETF, which invests in the banking sector. These ETFs are different from equity ETFs, which can invest in various sectors.

International ETFs

International ETFs allow investors to invest directly in foreign companies and mirror the performance of global market indices or country-specific indices. Examples include the MOSL NASDAQ 100 and HDFC World Index Fund. International ETFs are easy to invest in, as they allow investments in Indian rupees and for very low amounts. However, they differ from direct investments in international stocks in terms of price determination, taxation, and the process of investing.

Index ETFs

Index ETFs are designed to track a specific market index, such as the Nifty 50 or Sensex. They are the most common type of ETF and aim to replicate the performance of the underlying index.

Fixed Income ETFs

Fixed Income ETFs aim to provide exposure to various types of bonds, including government securities and corporate bonds.

Leveraged ETFs

Leveraged ETFs use derivatives or debt instruments to boost potential returns on an underlying index. However, these ETFs are not currently available in India.

Advantages of ETFs

Exchange-Traded Funds (ETFs) are a type of investment fund that combines the benefits of diversification offered by mutual funds with the ease of trading associated with equities. Here are some advantages of investing in ETFs:

Easy to Trade:

ETFs can be easily traded on stock exchanges, similar to shares. They offer the convenience of intra-day purchases and sales, allowing investors to take advantage of prevailing prices, which are typically close to the actual Net Asset Value (NAV) of the scheme. This provides investors with more freedom and flexibility to complete deals in real-time.

Cost-Effective:

ETFs are known for their low costs. They generally have lower expense ratios compared to actively managed funds, and the passive management style of ETFs contributes to reduced costs. Additionally, ETFs often have lower fees than other types of funds, and the savings are passed on to investors.

Tax Efficiency:

ETFs are more tax-efficient than actively managed mutual funds. As passively managed portfolios, they tend to generate fewer capital gains distributions, resulting in lower taxes for investors.

Diversification:

ETFs provide exposure to a wide range of securities, including stocks, bonds, commodities, and currencies. They allow investors to access various markets, industries, asset classes, and countries, helping to mitigate the impact of any single investment's poor performance on the overall portfolio. This diversification reduces an investor's risk and is achieved more easily and cost-effectively with ETFs than with individual stocks.

Reinvestment of Dividends:

ETFs automatically reinvest dividends, putting any profits made back into the investment to promote growth.

Limited Capital Gains Tax:

ETFs are designed to be tax-efficient, often resulting in lower taxes on profits. They tend to buy and sell less frequently, reducing the number of tax bills for investors.

Lower Price Volatility:

ETF prices tend to stay closer to the real value of the underlying assets. Market experts work to maintain fair pricing, reducing the likelihood of significant price jumps or drops.

Suitable for Various Investor Types:

ETFs are suitable for both long-term and short-term investors, including beginners. They eliminate the need for extensive research and expertise in individual stocks, making them accessible to a wide range of investors.

Costs of Investing in ETFs

When considering investing in ETFs, it is important to understand the associated costs. While ETFs generally have lower fees than other types of funds, there are still some costs to be aware of. Here are the key costs to consider when investing in ETFs in India:

• Brokerage Commission: ETFs are bought and sold through a broker, and investors pay a brokerage commission each time they make a purchase or sale. This is similar to the costs of trading stocks, where the difference in the ask-bid spread can impact the overall cost.
• Management Charges and Commission Fees: These fees vary depending on the ETF and can impact your overall returns. It is important to evaluate these fees when selecting an ETF to ensure they align with your investment goals.
• Trading Costs: If you invest small amounts frequently, trading costs can add up. In some cases, investing directly with a fund company in a no-load fund may be more cost-effective.
• Illiquidity: Some ETFs with low trading volumes may have high bid-ask spreads. This means that you will buy at a higher price and sell at a lower price, impacting your overall returns.
• Settlement Dates: ETF sales are typically settled two days after the transaction. This means that your money from an ETF sale is not immediately available for reinvestment, which can impact your investment strategies.
• Tax Implications: The tax implications of investing in ETFs depend on the type of ETF and your holding period. For Equity ETFs, the tax treatment is similar to capital gains from individual stocks. Long-term capital gains (holdings greater than 1 year) have different tax treatments than short-term capital gains (holdings less than 1 year). For Gold, Debt, and Other ETFs, the tax treatment has changed as of April 1, 2023, and these are now classified as short-term capital assets and taxed at the existing income tax slab rates.
• Expense Ratio: The expense ratio represents the ongoing costs of managing the ETF and is usually expressed as a percentage of the fund's total assets. A lower expense ratio means lower costs for investors. When selecting an ETF, it is important to consider the expense ratio to maximize your returns.
• Tracking Error: ETFs generally track a specific index or benchmark, but there can be a difference between the returns generated by the ETF and its underlying benchmark. This tracking error can impact your overall returns and should be considered when evaluating the performance of an ETF.

Understanding these costs is crucial for making informed investment decisions. By evaluating the fees, tax implications, and potential impacts of illiquidity and tracking errors, you can better assess the potential returns and risks associated with investing in ETFs in India.

Frequently asked questions