Five things you must remember while buying an exchange-traded fund

Mutual funds are launching new exchange traded funds (ETF). While some ETFs track broadly diversified indices whereas others focus on a sector or a theme. In a bull market, some of these ETFs look attractive to ride the market. But here are a few factors you should remember while investing in them.

Liquidity constraints

ETFs in India often suffer due to a paucity of liquidity. Investors may find it difficult to execute trade near net asset value barring ETFs tracking popular indices such as Nifty 50 and Bank Nifty. If you are a high net worth individual or have accumulated a sizeable number of units, then selling them can be an issue. If you are buying an ETF do check the assets under management of the scheme and the trading volume on the stock exchange. If you find both to be low, then you can consider investing through the fund of fund route. Many large AMCs have also launched a fund of fund schemes to feed into the ETF. These FoF schemes ensure liquidity at the end of day NAV, though at an additional cost.

Concentration risk

Do check the underlying portfolio of an ETF. Check the index it tracks and the constituents of the index. If there are too few stocks in the index or one or two stocks account for a large allocation then you should be careful. This happens in the sectoral index ETF. For example, take the example of ETFs tracking Nifty IT TRI. There are only 10 stocks in this index and Infosys and TCS together account for over 50% of the index. Investment success depends on how the sector does, and one adverse development in one of the stocks where the allocation is large can pull down the return on investment.

Past returns

Many first-time investors pick an ETF looking at the past returns. If the ETF has done well in the recent past, it is assumed it will keep performing. However, sometimes you may be entering an ETF tracking a sector that may be peaking. Such an ETF may show very good past returns. But it may not be the best bet at that moment in time. You have to figure out what will drive the future returns and set expectations accordingly. You can consult an advisor if need be.

Diversification need

To limit your downside you should have a diversified portfolio. When you are choosing a thematic ETF or a sectoral ETF allocate money wisely. Do not put all your money in units of one ETF. Ideally buy a bouquet of ETFs if you want to focus only on ETFs. Alternatively, one or two ETFs can be added to a portfolio of actively managed flexicap funds. Lack of diversification can be devastating. To achieve diversification across asset classes you can also allocate some money to ETFs investing in bonds or gold.

Tax implications

Gains on the sale of units of an ETF are subject to tax. ETF investing in Indian stocks is treated as equity funds. ETF investing in bonds, gold or stocks listed overseas are treated like debt funds. Gains realised on the sale of units of an equity ETF held for more than one year are treated as long-term gains. They are taxed at 10% if the gains exceed Rs 1 lakh in a given financial year. In other cases, the gains are treated as short-term capital gains and taxed at a 15% rate of tax.

In case of a non-equity ETF, gains realised on the sale of units of an equity ETF held for more than three years are treated as long-term gains. They are taxed at 20% post indexation. In other cases, the gains are treated as short-term capital gains and taxed as per the slab rate of the investor.