How Exchange Traded Funds Work
Because an ETF usually represent a basket of products/assets, this type of investment tends to own the assets underlying the fund. Such assets include but are not limited to company stocks, oil futures, gold, foreign currency, and bonds. In India, gold and index-linked ETFs are the most common types available to the individual investor. Subsequently, the ETF divides the total assets it owns into smaller units termed as shares, which can be traded on the exchange. Thus the current trading value of an ETF is based on the applicable value of net assets that the Exchange Traded Fund is comprised of at a specific point in time. For example in the case of a gold ETF which primarily holds gold bullion as the underlying asset, changes in the price of gold will cause a corresponding change in the price of ETF shares during the course of the trading day.
It is, however, important to note that unlike a company share, which denotes part ownership of the equity of the company an investor is invested in, shareholders of an ETF cannot stake claim to the underlying assets of the exchange traded fund. However, the shareholders of an ETF are liable to receive profits earned from the underlying assets in the form of dividends or interest earned. Moreover, in the case of ETF liquidation, the shareholders may also receive a residual value. As mentioned earlier, ETFs can be bought and sold on stock markets just like company shares, hence in lay terms, an ETF may be considered similar to a mutual fund that can be bought and sold on the stock exchange and whose trading value can change in real time.
Benefits of ETF Investments
- One of the key features of an ETF is the intra-day trading opportunity that these funds provide. As a result of this feature, short-term speculative investments can be carried out. These are usually in the form of “bets” that predict the upward or downward movement of the ETF share price. When done correctly this can be as lucrative as stock trades through a profit booking mechanism similar to equities. However unlike individual stock trades, an Exchange Traded Fund often closely mirrors the movement of the index thus the rise and fall of prices tend to be more predictable as compared to individual equities.
- The market trading benefit of an ETF extends well beyond the intra-day trade. Some of the other advanced trading techniques that are supported by an exchange traded fund include trading on margin, short selling, and various speculative strategies. Though these are not easy to perform successfully, they do provide traders the opportunity to earn huge profits in a short time.
- Exchange Traded Funds are often considered unique as they have a low expense ratio, which generating savings and can increase payouts in the long term. Such expense ratio savings can potentially be invested back into the investor’s portfolio allowing them to earn even more in the long term.
- Among the less discussed benefits of this investment, options are the ones that an ETF shares with index funds. Such benefits include but are not limited to broad diversification and low turnover, which enhances the stability of the investment. This added with the benefit of a low expense ratio have many investors convinced that an ETF is definitely the correct investment choice for those interested in trading actively.
- Diversification is another key benefit that an investor derives from Exchange Traded Fund investments. One can potentially choose from a wide range of ETFs which mainly differ on the basis of the underlying asset. Some of the leading ETF investment options available in India are Kotak PSU Bank ETF, SBI – ETF Nifty, Reliance ETF Dividend Opportunities, LIC MF ETF – Nifty 100, Reliance Shares Gold ETF and ICICI Prudential Gold iWIN ETF. In the above examples, the underlying assets include bonds, equities, and gold.
Limitations of ETF
- In a majority of cases, ETFs can be bought and sold through registered brokers and broking houses. However, many of these brokers charge the investor for the services offered. Thus the benefit of the low expense ratio might not seem relevant in the larger scheme of things. In order to minimize the potential impact of these broking charges, many investors adopt the approach of making large one-off trades, however, it might be easier to seek out and engage a broker who charges less instead.
- Volatility risk is often considered to be most appropriate when talking about equity investments. However, that actually holds true for all sorts of things that are bought and sold on an exchange. Thus ETFs being exchange-traded are not immune to a degree of share price volatility, which can impact the value of investments considerably depending upon the direction of the price change.
Tax Considerations of ETF Investments
The ETF investments are subject to separate rules based on the underlying asset of the fund. In case the underlying asset is a commodity such as gold, the taxation rules would be the same as in the case of profits generated from sale/trade of non-equity mutual fund investments. Alternately, if the underlying asset is equity-oriented such as in the case of an Index ETF, taxation rules of equity mutual funds will apply to the ETF.
The equity mutual fund rules of taxation that apply to Index ETFs involve short term and long term capital gains. Profits received from the trade/sale of ETF shares are considered as short term capital gains if the shares were held for less than 1 year from the date of allotment. Short-term capital gains are taxed at the rate of 15% in case of equity-oriented ETF as per current rules. Long-term capital gains rule in the case of this type of ETF is applicable to shares that have been held for a period of over 1 year from the date of allotment. As per current taxation rules, long-term capital gains in case of equity-oriented investments are completely tax exempt.
Non-equity mutual funds and by extension ETFs such as a gold ETF are subject to a different set of short term and long term capital gains rules. Short term gains, in this case, imply profits generated through trade/sale of ETF shares prior to completion of 3 years from the date of investment. Such profits are added to the annual income of the investor for the applicable year and taxed according to applicable slab rate. Shares in ETF that are held for over 3 years from the date of allotment are subject to long-term capital gains rules. At present, non-equity oriented ETF such as a gold ETF is taxed at 10% before indexation and 20% after indexation benefits.
Gold ETF vs. Gold Funds
Exchange Traded Funds might have emerged as an alternative investment route for individual investors and this has also led to a class of mutual funds that exclusively invest in ETFs. The prime example of this is a typical gold fund that primarily invests in one or more gold ETFs. In such a situation, the gold ETF invests a major portion of its assets in physical gold, while the gold fund buys the share of the gold ETF. For an investor purchasing the gold ETF-based mutual fund is much easier as no DEMAT account is required and a free of cost investment account from Paisabazaar.com can be used to make such a purchase. Moreover, gold funds are much less prone to volatility as compared to gold ETF, while an increase in the price of gold assets that form the ETF portfolio will push the price of gold funds upwards. Thus many investors have preferred to invest indirectly into gold Exchange Traded Funds through the mutual fund route as compared to investing directly in an Exchange Traded Fund.