Decoding Exchange Traded Funds!

Published by Shitij Goyal on

We talk about Finance and financial independence a lot today than we used to do some time back. The reason is very evident that is the cash crunch and the economic crash that has made us much more aware not only on the savings front but also on the investments front.

As our expenditures were limited due to the restrictive use of money in lockdown, people looked for varied investment options that are safe and liquid at one side and provide high returns on the other. Many options came to this like gold, bank instruments, stocks, mutual funds, etc. but you got that right, STOCKS was the first thing that comes to people’s minds and this made 1.2 million people open Demat accounts in the country.

Investment in stocks can be done in multiple ways and we will be discussing the Exchange Traded Funds (ETFs) option. Let’s understand funds first, so a lot of people wish to invest in stocks but have a small capital, therefore an Asset Management Company (AMC) takes the responsibility to pool these funds and collectively invest the money in well-worth companies of the nation.

Funds can be said to be a major of two types that are passively managed funds and actively managed funds. Passively managed funds are when the AMC does not choose the stocks or research on its behalf but directly invests in the index of which the fund is of. For eg- If we are buying a NIFTY ETF, then the AMC will invest its pool of funds in the same ratio and same stocks that NIFTY constitutes. This ensures that the ETF performs the same way NIFTY does, it replicates NIFTY.

Now, actively managed funds refer to when the AMC hires professional which look for undervalued and high growth stocks to maximize the returns of the people who have invested with them. Passively managed funds charge less fess than actively managed funds and in the global scenario, 99% of the ETFs that we talk about belonging to the passively managed category.

Exchange-Traded Funds as the name suggests are the funds that are traded on the stock exchanges. These provide mobility to the people in the sense that they can get whole exposure of the nifty market in one single investment and they also have the option to enter or exit anytime from it.

An exchange-traded fund (ETF) is a type of security that involves a collection of securities such as stocks. ETFs are in many ways similar to mutual funds; however, they are listed on exchanges, and ETF shares trade throughout the day just like an ordinary stock. ETFs can be formed in many ways by making a basket of stocks like Largecap Top50, Midcap Top50, Smallcap Top50, etc. These also help the economy in a great way.

Exchange-Traded Funds seems to be a very lucrative option to the retail investors as $4.7 Trillion is invested worldwide in it because they get good sustainable returns from it and also they don’t have any tension to select stocks to invest in. They can just see if the economy or NIFTY/SENSEX will go up, their ETF will go up, and hence it is proved to be a good investment as it provides moderate returns with a lesser degree of risk.

ETFs from an Economy point of view

ETFs are a great tracker for the economy. They help the economy to grow in times of distress like the recent scenario. When the stock market goes down, people look up to investing in ETF as these bear less risk and people get an opportunity to invest when the economy is in a recovering slope. When a market traced ETF goes up, it can be said that the overall economy of the country is going up and vice versa. Also, there are various ETFs that are linked to specific industries( power, cement, automobile, banking, gold) so investing in those gives an idea that which industry is fostering well in the overall economic environment of the country. There are ETFs that are based on market capitalization such as large-cap, mid-cap and small-cap, so the trend in these tells us the economy is framing better policies for which segment of the economy.

Advantages and Disadvantages of ETFs

ETFs provide a lower cost advantage since it would be expensive for an investor to buy all the stocks held in an ETF portfolio individually. Investors only need to execute one transaction to buy and one transaction to sell, which leads to fewer broker commissions. Brokers typically charge a commission for each trade. Some brokers even offer no-commission trading on certain low-cost ETFs reducing costs for investors even further.

An ETF’s expense ratio is the cost to manage and operate the fund. ETFs typically have low expenses since they track an index. For example, if an ETF tracks the S&P 500 index, it might contain all 500 stocks from the S&P making it a passively-managed fund and less time-intensive.

ETFs and Taxes

An ETF is more tax-efficient than a mutual fund since most buying and selling occurs through an exchange and the AMC does not need to sell shares each time an investor wishes to sell, or issue new shares each time an investor wishes to buy. Redeeming shares of a fund can trigger a tax liability so listing the shares on an exchange can keep tax costs lower. In the case of a mutual fund, each time an investor sells their shares they sell it back to the fund and incur a tax liability that can be created that must be paid by the shareholders of the fund. Tax benefits include zero tax liability on the profit of ETF if sold after 1 year. If the ETF is sold within a year, a short term capital gain tax of 15% is imposed on the profit gained.

ETFs Market Impact

Since ETFs have become increasingly popular with investors, many new funds have been created resulting in low trading volumes for some of them. The result can lead to investors not being able to buy and sell shares of a low-volume ETF easily.

Written By- Shitij Goyal


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1 Comment

Aditya · November 12, 2020 at 1:05 pm

Nicely expained. Please elaborate more on the taxation part. Not sure if there is no tax on profit on ETF sold after 1 year. Also equity ETF follow a bit different rule I suppose.

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