Exchange Traded Funds or ETFs are marketable securities that trade like stocks on stock exchanges. The underlying assets in ETFs can be stocks comprising an index, a specific commodity such as gold, a sector, or even a set of stocks bound by a common theme or characteristic.

For example, an ETF can mimic the composition of the Nifty or Sensex indices. This means the fund invests in a basket of securities which are part of a pre-decided index.

An ETF is like an open-ended mutual fund as it also benchmarks its holdings against a particular index.

How to start investing in ETF

You can invest in ETFs through a demat account with any authorized depositories. You need a demat account, trading account, and a bank account to transfer and deposit money for share transactions. Most depositories open 3-in-1 accounts.

Once the account is open, you can transfer money from your savings account to the trading account and start investing in stocks and ETFs.

Taxation of ETFs

ETFs are taxed similar to the way equities are taxed. An investment tenure of more than a year is considered long term. Short Term Capital Gains are taxed at 15%. The Long Term Capital Gain (LTCG) on the other hand is exempted.

One of the most popular ETFs is gold ETF and the taxation norms are different for it. In case of STCG, the capital gain is added to the income and taxed according to the tax slab applicable. The Long Term Capital Gain is taxed at 20% with indexation benefit. Long term in gold ETFs is defined to be a period over three years.

Advantages of ETF

Since most ETFs follow indices, the returns will match those of the underlying indices. In such cases, all the money received is invested in equities and none in cash. In case of actively managed funds, the fund manager keeps shuffling the underlying companies based on the performance and his or her analysis. While mutual funds are run by competent managers, you still run the risk of falling short of market returns. Moreover, fund managers keep some money in cash or liquid investments, which earn very little returns.

ETFs cover many asset categories today. Prominently, many are based on Gold, Nifty, Top 100, Top 200, banking sector, next 50 firms after the Nifty, and many more.

Moreover, the expense ratio in ETFs is lower compared to most mutual funds. Since ETFs track an index, the fund manager doesn’t have to actively find new opportunities for the fund portfolio. If any company goes out of the index, it will be out of the ETF automatically.

Finally, a few fund houses also offer ETFs based on foreign indices. You can invest in foreign companies through such ETFs.

Disadvantages of ETF

One of the disadvantages of ETF is limited choice of funds available compared to regular mutual funds, which are available in plenty. There are a few dozen ETFs in India, while mutual fund schemes run into the thousands. Hence, your choices in ETFs are limited.

This leads to other consequences: you can’t invest in new industries, emerging companies, or emerging theme-based funds. You have to rely largely on index-based funds. While an index comprises of large, financially strong, and stable firms, the growth companies are often left out of the space.

Finally, the ETF space has left many themes and sectors untouched as of now. Sectors like manufacturing, real estate etc. do not have any ETF based upon them.

Till the ETF marketplace evolves to include and offer the options that investors seek, it is likely to attract fewer investors than the mutual fund market. However, investors who wish to mimic the growth of indices such as Sensex and Nifty at low investment costs, or wish to invest in gold minus the troubles of storing physical gold, may find ETFs useful.

(The writer is CEO, BankBazaar.com)