What are ETFs? How do these differ from mutual funds?

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Rajiv has been investing in mutual funds. But these days he is gathering information about Exchange Traded Funds or ETFs. After thorough research, he found that this is also a type of mutual fund but it is also traded in the stock market. He also came across the fact that companies charge less expenses from investors meaning ETF’s expense ratio is cheaper on the lines of passive funds.

Rajeev felt that the most important thing about ETF is that it has lower risk as compared to stocks. Rajeev is among those investors whose interest in ETFs is rising day by day.

The same thing has been the find of a survey named “Decoding ETF Perceptions” by Mirae Asset Mutual Fund in November 2023. You can download the survey report from the following link:

https://innowave2023webinar.virtualconsole.in/

More than two thousand investors from 15 metro and tier-2 cities were the respondents. 60 percent of the respondents claimed that they have a good understanding about ETFs. There are two important reasons for rising investment trend in the ETF market. First, liquidity i.e. ETFs can be sold at any time during the market trading period. And second, low cost of ETFs i.e. low expense ratio.

So, lets see what are ETFs? And, how are these different from mutual funds?

Exchange Traded Fund, commonly known as ETF is an investment option in which investment is made in a set of securities. i.e. shares of different companies or even different types of bonds. ETFs trade on a stock exchange just like stocks.

ETF is a passive investment. It usually tracks assets and bonds listed on a specific index, or part of a specific sector or theme. The performance of ETFs is similar to the indexes tracked. E.g. many ETFs track indices like Nifty, Sensex, Nifty Healthcare Index or BSE 500. Money is invested in only those shares which are part of a particular index. Plus, investment is made in the index in the same ratio as that of the index constituents.

ETFs come in not only equity options but also debt and gold options. There are many types of ETFs available in the country today like Gold ETF, Silver ETF, Debt ETF, Equity ETF, Index and so on.

You can keep ETFs in a demat account just like you keep shares or other securities. The price of ETFs depends on the demand and supply.

As far as tax is concerned, equity ETFs are taxed similarly to shares or equity mutual funds. 15 per cent tax is levied on selling ETFs before 12 months. If you sell the ETF after holding it for one year, then, long term capital gains tax of 10 per cent on profits above Rs 1 lakh in a financial year will be levied. No tax on long term capital gains is levied on profits of up to Rs 1 lakh.

Taxes will be applicable on profits made from other types of ETFs like Gold, Debt or International ETFs as per the income tax slab irrespective of the holding period.

Mirae Asset Mutual Fund, ETF Products, Head, Siddharth Srivastav, said, “People are investing in ETFs to benefit from the rapid growth rise of the market. Additionally, ETFs have lower costs and entail less risk. This is why ETFs are rapidly gaining popularity.”

Siddharth goes on to add, “There are positive signs in the market in 2024. Whether we talk about economic indicators or the trends of corporate earnings, it seems that the market will perform well. Even though it may not repeat its performance of 2023, the Indian market is looking set for significant upsurge in the long run.”

Now, lets see how much returns people have made by investing in ETFs:

Index ETF has given double digit returns in the last one to three years. Whereas, Gold ETF has given an average return of 12.25 percent in last one year. While, in the last 5 years, it has given an average return of about 14 percent. These statistics are as of December 19, 2023.

ETFs are more diversified. i.e. investments are made in different number of shares. Therefore, investing in ETFs is less riskier than investing in individual equities.

Watchout! Tracking error is an important term in ETFs:

Tracking error is the difference between the benchmark index’s return and the ETF’s return. In fact, it shows the difference between the performance of the ETF and the benchmark index.

The ETF with the least tracking error will be slightly better. Less tracking error would have lower impact on your returns. So, investors should choose such ETFs which have minimum tracking error.

Now let’s see how ETFs are different from mutual funds:

ETFs trade on the stock exchange and investors can buy and sell the ETFs on the exchange itself. Whereas, to buy or sell units of a mutual fund, a request has to be given to the fund house. The price of a single unit of a mutual fund is known from its NAV. ETFs do not require active management, as these track the performance of a particular index and try to perform similarly.

This is the reason why it is cheaper to invest in ETFs. In case of mutual funds, the fund manager takes investment decisions on behalf of the investors and due to this the management cost is also high.

Mutual funds levy around 1.5 to 3 per cent fees annually. Whereas, ETFs levy around 0.10 percent fees, which is much lower than that of mutual funds. Lower costs in ETFs would result in much better long-term returns.

There is no minimum holding period in ETFs:

The investor can buy and sell it any time. Whereas, mutual funds like Equity Linked Savings Scheme i.e. ELSS have a lock-in period of three years. You cannot exit your investment within this time period. Many mutual fund schemes levy an exit load.

A Demat account is necessary to invest in ETFs. Whereas, you can invest in mutual funds without the requirement of having the demat account.

ETF is becoming the preferred option for those investors who want to create wealth at low investment costs. Generally, investors think of investing in ETFs rather than mutual funds because the charges are lower.

ETFs can be a better option for those investors who can take a lower risk. But remember, whether it is a mutual fund or ETF, both have their own advantages and disadvantages. Investors should make a decision based on their investment strategy and risk appetite.