Exchange Traded Funds or ETFs in India are becoming one of the fastest growing favourite investments for passive investors over the last few years.
Infact, if you’re looking to invest your money in a well diversified investment, with little active management from your side and at an extremely low cost, then ETFs are A GREAT CHOICE for you!
Why? What is an ETF? And what gives ETFs that edge?
Let’s find out!
What is an ETF?
The best explanation of an ETF is : A mutual fund that simply mimics an index. The fund holds what the index holds, in the same proportion and changes it when the index does. In other words, it is a passively managed mutual fund where the fund manager does not take any active call on what stocks to buy or sell.
So what’s so great about that?
It’s that you remove human intervention and go with the market wisdom. A fund manager can take wrong calls; the performance of an active fund can dip when this happens. With a passive fund, you simply go with the index. This way you eliminate the risk of subjective calls. Of course, your ETF will fall when the index/market falls and vice versa.
A ETF can mimic an equity index, debt index or a commodity(like gold). In India, equity ETFs and gold ETFs are quite popular while debt ETFs are just gaining ground.
An ETF can be bought or sold like a stock in the stock exchange. This distinguishes it from another class of mutual funds called index funds. Unlike a mutual fund, which can be bought/sold only at the end of day price called NAV, an ETF can be traded live in the stock market, like a stock. This is why it is called an ‘exchange traded fund’.
How is an ETF structured?
An ETF is a basket of stocks structured to mimic the index on which it is built. So if we take say the Nippon India Nifty BeES, and the share of Infosys accounts for say 8% of this index, then,the job of Nippon India Nifty BeES is to ensure that it holds this stock in exactly the same proportion at all times. It has to do so with all 50 stocks in the index. The advantage of this is two-fold:
- One the structure allows you to track the index without you having to manually do the rebalancing yourself.
- Two and very importantly, it allows you to hold a large basket of stocks without your having to buy them individually.
Let’s take the example of ICICI Prudential NIFTY 50 ETF to explain this..
Here, ICICI Pru AMC buys all the shares of NIFTY 50 (The Index) proportionately. They then group them into different baskets. The cost of each basket would be approximately 1 lakh. They then split the basket into 100 different units and sell each of them individually as ETFs. These shares are then traded on the stock exchange like a stock. You can buy them and sell them whenever you want.
A big advantage here is that you can get exposure to a lot of securities that are otherwise too expensive. For example, at the time of writing this, you could have bought a ICICI Nifty ETF at just Rs 137 per unit instead of spending over Rs 1 lakh to get one stock each of the Nifty 50. And to top it, the ETF is going to ensure your stock weights remain exactly the same as the index.
When we talk of the structure of an ETF, you also need to know a very important point on the price of an ETF. There are 2 levels of price for an ETF. One is the NAV. The second is the market price. NAV is the per unit value of the underlying instruments in the ETF. It is no different from the NAV of active mutual funds. It changes every day, end of day and represents the true value of the ETF less its expense ratio (cost of managing the ETF). Ideally, this is the price at which an ETF should trade in the exchange.
However, it seldom does. This is because of the demand and supply of the ETF. When more investors want to buy the ETF and there are fewer sellers, the market price is more than the NAV as there is more demand for the ETF. When more investors sell the ETF and there are fewer takers, then the ETF market price can go below the NAV as the supply is high compared with demand. As an investor, the ideal thing for you is to look for ETFs that are closer to their NAV.
Creation and Redemption of an ETF
So if the demand and supply situation remains skewed will the price go out of whack?
Luckily for us, the Asset Management Companies have thought this through and appointed “Authorized Participants”.
If nobody wants to sell their ETFs, and there are buyers wanting to get more, the price of the ETF will go up (because there is more demand for it). Now, because the price of the ETF has gone up but the price of the underlying stocks is still the same, these Authorised Participants will buy the underlying stocks and sell their ETFs.
On the other hand, if nobody wants to buy an ETF, the price of the ETF will go down. These Authorised participants will then buy the ETF and sell their underlying stock.
This is how ETFs are always balanced and track the index.
Advantages of ETFs
Now that you know what an ETF is and how it is structured, let’s look at why you NEED them and how they can help you.
An ETF is super diverse! All ETFs in India – and the world – invest in indices. These indices consist of a large group of stocks.
Example : A NIFTY ETF consists of 50 different stocks in many categories. A BankBees ETF invests in all the banking stocks in that index.
Because the ETFs invest in different stocks in the index even if one stock falls, your investment is still safe.
When you’re investing in an ETF, you do not have to do any research before buying the index unlike a stock. You can simply buy the ETF and let it sit in your portfolio and watch it grow. Since most of the indices are market-cap based, your ETF will always hold higher weights to rallying stocks and lower weights to those that fall. So you go with the market wisdom.
VERY LOW COST
ETFs have very low costs when compared to mutual funds. An actively managed mutual fund costs approximately around 0.1-1.25% under the direct plan This means that the returns you get are AFTER this cost. For an equity ETF, the average cost is at around 0.3% while it is as low as 0.05% for many. But you need to note that there are other costs to an ETF that you may not be aware of. Read about it here.
The graph below will tell you that from a decade of outperformance in the early 2000s, the margin of outperformance of active large-cap funds dwindled. ETFs in fact deliver better as most large-cap funds now struggle to beat the index. The lower cost of ETFs is a key reason for this performance gap.
EXPOSURE TO BROAD MARKETS WITH LIMITED MONEY
If you wanted the same returns of the NIFTY index, you would buy all the stocks in the NIFTY 50 index. In this process you would end up spending ₹1,15,006.65 (as on 19th November). Instead of spending 6-8 months of your salary on buying stocks simply for getting the same return, you can buy the NIFTY ETF for less than ₹150. After investing in an ETF, you will get the same return while getting exposure to a new index and market with limited capital.
Buying all the stocks in the NIFTY index is going to take you a really long time. Buying an ETF will take you 5 seconds.
LOTS OF OPTIONS
There are ETFs for EVERY single asset class. Want an equity ETF? Done. Gold ETF? Yep. Bonds ETF? Yes, Sir.
EASY TO BUY AND SELL
An ETF can be bought or sold just as easily as a stock. All you have to do is enter the name of the ETF, enter the quantity you want to buy and click buy and you’re done!
An ETF mirrors the return of the underlying index. So if you have a gold ETF and the prices of gold have shot up in the future, your investment will also go up by the same amount.
How are ETFs in India taxed?
Each type of ETF in India is taxed exactly like its mutual fund counterpart.
If you buy an equity ETF and sell it within 1 year, your profits for that 1 year will be taxed at 15%. That tax is called Short Term Capital Gains Tax.
Similarly, if you buy an Equity ETF and sell it after 1 year, your profits for that ETF will be taxed at 10%. That tax is called Long Term Capital Gains Tax.
It gets slightly more tricky when it comes to debt funds.
If you buy a debt ETF and sell it within 3 years, you will be taxed at your current tax slab rate.
If you buy a debt ETF and sell it after 3 years, you have to follow a process called indexing your costs and then pay a 20% tax on the profits.
[ Indexing your costs means adjusting your buying price (the cost at which you bought your debt ETF) for today’s inflation rate. So essentially you end up paying less taxes because your buying price is “indexed” for today’s inflation. ]
If you buy a gold ETF and sell it within 3 years, you will be taxed at 20% of your profits.
If you buy a gold ETF and sell it after 3 years, you will be taxed at 20.8% of your profits after allowing for indexation.
Criteria for selecting ETFs in India
Good liquidity is when you want to buy an ETF there are enough sellers in the market to satisfy your order and when you want to sell an ETF, there are enough buyers in the market. This is important because you do not want to be stuck with an ETF when you’re trying to sell or not be able to buy them because there are no sellers.
The total ETF liquidity is made up of both ETF shares traded in the secondary market and shares that can be created and redeemed in the primary market (as discussed above).
COST OF RUNNING THE ETF
The cost of an ETF is an extremely crucial criteria in selecting an ETF in India. The lower the costs of the ETF the closer its return will be to the index. When looking at cost make sure that it is cheaper than the cost of the mutual fund of the same underlying assets. If it’s not then you might as well buy the mutual fund or the asset directly.
COST OF THE BROKERAGE
Every brokerage firm has a different cost structure. The one thing all of them have in common is they charge you a small commission when you buy and when you sell. When buying ETFs in India, make sure you pick a brokerage firm that does not manage to overcharge you for buying ETFs. The new-age online platforms all provide trading at competitive costs.
Every ETF “tracks” a particular asset. If it is a gold ETF, the value of the ETF will grow as the price of gold grows. Sometimes, this value might differ. For example, the price of gold might go up by 15% in one year but the ETF will go up by 15.1% or 14.9%. This difference is called tracking error. The lower this tracking error is for the ETF, the better.
Where can you find the best ETFs in India?
As I write this, there are 77 ETFs in India. Now that you know what criteria to look for in an ETF, you need to decide which ETF is best suited for your needs. To do that you have to first decide what type of ETF you need. There are many different types of ETFs in India (Equity ETFs, Sector ETFs, Thematic ETFs, International ETFs, Commodity ETFs & Debt ETFs). Each of these ETFs track a different underlying asset and give you different returns. Understanding your goals clearly and understanding the underlying asset class will help you choose the right ETF.
This might seem like a lot of work but it’s crucial that you do it. Luckily for you, we already have select analysis on ETFs. At PrimeInvestor, we do all the number crunching, sift through the whole universe of ETFs to tell you the best ETFs and also let you know how you can use them.
How can you buy an ETF in India?
All right! Now that you know what an ETF is, why you need it and exactly which ETF you want, all that’s left is to buy it. So how do you really buy an ETF?
The first thing you need to buy an ETF is a Demat account. To put simply, a demat account is an account you hold with a brokerage firm to buy and sell stocks, mutual funds, bonds and of course, ETFs. Find a brokerage firm that suits your needs and one that you are comfortable with and ask them to open a demat account for you. It will probably take 10-15 minutes max.
Once you open your demat, type in the name of the ETF you want to buy and then click buy. Et Voila! You are now a proud owner of an ETF.
When you buy an ETF during the new fund offer period, you get units directly allocated by the AMC. Post the NFO period, the units so issued are traded in the market like a stock. And you can buy or sell them. If you are a very large investor, you can still approach the AMC directly and buy these at the ‘NAV’ price instead of the market price.
*Pro Tip* When you’re typing the name of the ETF, just type in the name of the underlying asset and then type ETF. This will automatically show you all the AMCs that offer that particular ETF. Then go ahead and select the AMC of your choice.
What if you don’t want to open a Demat account? You can buy index funds. You can read about the difference between ETFs and index funds here and decide which one suits you.
You’ve bought an ETF. Now what?
Now that you have bought an ETF, the next question you should be asking yourself is “when should I sell it” and “how long should I hold it?”.
The best answer for that question is : ALAP (As long as possible) or until you reach your goal!
The stock market is a function of time and money. The more money you put in and the longer you wait the more your money will compound and continue to grow.
Therefore, when investing in an ETF, keep your money invested until it has grown sufficiently to meet your goals. This could be 5, 10,15 or maybe even 20 years. Remember, the longer you hold onto it the more your money will grow.
When investing in a slightly volatile ETF like an equity ETF, it is better to invest via SIPs rather than lumpsum because you get to take advantage of price swings in the market. So try to keep investing a regular amount every month in ETFs because this will help you remove the pressure of getting into the market at the “right time” or in other words, “timing the market”.
Also Read : An overview of ETFs in India and how to choose them & ETFs in India.