Exchange Traded Funds

Exchange-traded funds are one of the most important and valuable investment products created for individual investors in recent years. If used wisely, ETFs offer many benefits and are an excellent vehicle to achieve an investor’s investment goals. An exchange-traded fund (ETF) is a basket of securities you buy or sell through a brokerage firm on a stock exchange. ETFs are offered in virtually all asset classes, from traditional investments to alternative assets like commodities or currencies.

LEARNING OUTCOMES

At the end of the course, you will be able to understand:

• How an ETF Works?
• Different Types of ETFs.
• ETF and other Investments.
• Benefits of Investing in ETFs.
• ETF Tax Benefits

How does an ETF Work?

Like company shares, ETFs are listed on stock exchanges and can be bought and sold during trading hours. Also, like listed stocks, an ETF will have a ticker symbol and intraday prices.

They differ from company stocks because the number of units available in an ETF can change daily due to the continuous creation and redemption of existing units in an ETF. The market price of an ETF is usually kept in line with its underlying securities on an ongoing basis due to the ability of an ETF to issue and redeem units in itself.

In summary, characteristics of ETFs. are as follows:-

• They are traded like equities, which makes their prices visible in real-time.
• They can be sold or purchased at any time during trading sessions.
• They are a single instrument that contains several trading instruments, including shares and fixed-income securities.
• They are not exclusively available to corporate investors or large participants in financial markets.

Generally, ETFs are outstanding investment choices. They could be bought and sold in real-time and have lower management fees than ordinary funds. For these reasons, ETFs are also starting to replace mutual funds as the default investment vehicle.

Features of ETFs

Salient features of Exchange Traded Funds

Access

ETFs offer a variety of broad and targeted exposures across virtually all asset classes, regions, sectors, and specialties.

Cost Effectiveness

ETFs are typically lower-cost investments than comparable investments, such as actively managed funds, as the management fees incurred in ETFs tend to be lower.

Transparency

Information on holdings, performance, and costs is published daily and freely available.

Diversification

ETFs, offer access to multiple investments in a given index in one transaction, helping investors to spread risk.

Flexibility

ETFs are traded on exchanges, like company shares, making it simple to buy or sell when markets open.

Types of ETFs

Types of ETFs available for investment are:

Market ETF

Designed to track a particular index like the BSE Sensex or NSE Nifty.

Bond ETF

Designed to provide exposure to every type of bond available; Government of India Bonds, corporate, municipal, international, high-yield bonds, etc.

Sector and industry ETF

Designed to provide exposure to a particular industry, such as oil, pharmaceuticals, or high technology.

Commodity ETF

Designed to track the price of a commodity, such as gold, crude oil, etc.

Style ETF

Designed to track an investment style or market capitalization focus, such as large-cap value or small-cap growth.

Foreign market ETF

Designed to track non-Indian markets, such as Japan’s Nikkei Index or Hong Kong’s Hang Seng index, etc.

Inverse ETF

Designed to profit from a decline in the underlying market or index.

Actively Managed ETF

Designed to outperform an index, unlike most ETFs designed to track an index.

Alternative investment ETF

Innovative structures, such as ETFs, allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call writing.

Equity ETF

Exchange-traded funds are subject to risks similar to those of stocks. Investment returns will fluctuate and are subject to market volatility such that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost.

Unlike mutual funds, ETF shares are not individually redeemable directly with the ETF but must be bought and sold on an exchange, like individual equity. ETFs are sold by prospectus.

There is a wide array of equity ETFs to choose from, so knowing about the various subtypes can help to find one that fits your portfolio. Depending on the index tracked by the ETF, it may own stocks issued by companies from around the world or limit its investable universe to companies of a country. Some ETFs allow companies of all styles and sizes, while others limit their holdings based on the particular characteristics of a company. Because there are so many variables, the number of stocks held by an ETF can range from less than 25 to over 100.

Some of the Equity ETFs

• Sector ETFs
• Dividend ETFs
• International ETFs
• Market-Cap ETFs

Fixed Income ETF

Key Features of Fixed Income ETFs

• Investors may purchase bond ETFs that focus on specific ranges of maturity dates.
• Many bond mutual funds are actively managed and may have significant turnover in their portfolios.
• Fixed Income ETFs may also pay regular interest and typically do not have a specific maturity date.
• Investors with shares in bond ETFs may have more ready access to information about fund holdings. The underlying securities of fixed-income ETFs usually are reported daily online. Bond mutual funds, by contrast, are required to reveal their holdings semiannually, although many do so more frequently — often monthly — on their Web sites.

Types Of Fixed Income ETFs

Most Fixed Income ETFs fall into one of four main categories:

• Sovereign: Tracks bonds issued by the governments of sovereign nations.
• Corporate: Tracks fixed income securities or bonds issued by corporations.
• Municipals: Tracks bonds issued by local municipalities.
• Broad Market: Tracks some blend of the above.

Index ETF

What is an Index?

An Index is designed to measure, as closely as possible, the value of a specific financial market or segment of that market. It is a basket of stocks, bonds, commodities, or other assets whose overall price level, risk, and return are standard measurements. Investors use indexes as a benchmark to gauge the performance of any stock, bond, or mutual fund against overall market performance.

Index ETF

Index ETFs are Exchange Traded funds whose returns closely correspond with the returns of benchmark indices. Simply put, the price fluctuations in Index ETFs are directly linked to the index it follows, as the Index ETF buys shares that proportionately reflect the securities of the corresponding index.

Benefits of Investing in an Index ETF

• Less volatility than industry-specific and strategy-specific ETFs because they hold a wider variety of stocks.
• The bid-ask spreads on popular index ETFs tend to be tight, so orders can be filled quickly and efficiently.
• Index ETFs tend to be among the lowest-cost ETFs because there is minimal portfolio turnover and research costs.

Commodity ETF

Commodity ETFs invest in physical commodities such as natural resources, agricultural goods, and precious metals.

A commodity ETF could have its investment in a single commodity with its physical storage or may invest in futures contracts. Alternative commodity ETFs look to track the performance of a commodity index that includes dozens of individual commodities through physical storage and derivatives positions.

Types of Commodity ETFs

• Physically backed funds
• Futures-based funds

Historically, directly investing in commodities was perceived as risky and costly. Commodity ETFs have helped remove some of these barriers. By investing in an ETF, new and experienced investors don’t have to learn how to buy futures or other derivative contracts. They, too, can enjoy the benefits that commodities have to offer.

Gold ETF

A Gold ETF is an exchange-traded fund (ETF) that aims to track the domestic physical gold price. They are passive investment instruments that are based on gold prices and invest in physical gold.

In short, Gold ETFs are units representing physical gold in paper or materialized form. One Gold ETF unit is equal to 1 gram of gold and is backed by very high purity physical gold. Gold ETFs combine the flexibility of stock investment and the simplicity of gold investments.

Gold ETFs are listed and traded in the cash market segment of stock exchanges like BSE & NSE, like any other company stock, and could be bought and sold continuously at market prices.

Buying Gold ETFs means you are purchasing gold in an electronic form. You can buy and sell gold ETFs just as you trade in stocks. When you redeem Gold ETF, you don’t get physical gold but receive the cash equivalent. Trading of gold ETFs takes place through a dematerialized account (Demat) and a broker, which makes it a highly convenient way of electronically investing in gold.

Because of its direct gold pricing, there is complete transparency in the holdings of a Gold ETF. Further, ETFs have much lower expenses than physical gold investments due to their unique structure and creation mechanism.

Benefits of buying Gold ETF

• The purity of the gold is guaranteed, and each unit is backed by physical gold of high purity.
• Transparent and real-time gold prices.
• Listed and traded on the stock exchange.
• No fear of theft – Safe and secure as units held in Demat. One also saves on safe deposit locker charges.
• ETFs are accepted as collateral for loans.
• No entry and exit load.

ETF Investment Strategy

An ETF strategy is a methodology created by traders and investors to select the best ETFs to trade or invest in that suit their individual needs. Essentially, it helps to make buy and sell decisions using consistent tools and data points. The methodology typically involves a range of different types of analysis, which mainly fall under technical analysis or fundamental analysis.

Technical Analysis

This type of analysis involves analyzing the movement of price to identify patterns of repeatable behavior. Many traders use technical indicators such as moving averages and the stochastic oscillator on a price chart of an ETF to look for patterns that result in buying or selling opportunities.

Fundamental Analysis

This involves analyzing fundamental data such as changes in global economic activity, central bank policy, and macroeconomic indicators that identify changing trends in the world economy, technology, and climate.

Most traders and investors use a combination of both technical and fundamental analysis.

However, short-term traders, such as day traders, who only hold trades for minutes or hours, will be more focused on a trading strategy that is predominantly focused on just technical analysis. Fortunately, the technical analysis tools used to trade on other markets, such as currencies, shares, and commodities, could also be used in ETFs.

Essential Points While Trading and Investing in an ETF

Check the ETF NAV

One of the most significant benefits of ETFs is their transparency; by using what is known as the “NAV” or indicative net asset value, you can, for many ETFs, get an estimate of the “fair value” of the fund in real time through the trading day. You can use this data to get a more accurate sense of the value of your investments and make better purchase or sale decisions. When trading through your online broker, after looking at the NAV (where available), you can make better decisions about the price you want to buy and sell at.

Use a Limit Order

When trading through your online broker, after looking at the NAV (where available), you can make better decisions about the price you want to buy and sell at.

You don’t have to set a price limit to purchase ETFs (known as a “limit order”). Still, it’s strongly advised to do so, as, in a volatile market, several factors can come together that can either drop the sale price or raise the buy price beyond what you’re comfortable with by the time your order has been placed fulfilled. Limit orders can prevent this from happening.

On-screen Trading Volume is not an Indicator of Liquidity.

If an ETF hasn’t traded much during the day but wants to purchase or sell units, you can still do so, which is a fundamental difference and advantage that ETFs have compared to standard stocks.

Avoid Trading in the First and Last 15 minutes of the Day

During the first and last 15 minutes of the trading day, when the markets are opening and closing, there can be less information available to value certain shares or a lot more volatility in share prices.

In this situation, the market maker’s spreads may be more comprehensive, and the NAV may be based on a price that can move significantly within a minute or two. You should, therefore, consider trading the ETF when stocks have settled down, usually 15 minutes after the markets open to 15 minutes before they close.

ETFs Vs. Listed Shares

ETFs combine the benefits of managed funds and listed shares

ETFs, combine characteristics of traditional unlisted managed funds with the benefits of listed shares. Like managed funds, ETFs pool money from investors into a ‘fund’ that is professionally managed.

Like listed shares, ETFs trade on the stock exchanges like BSE and NSE, so investors benefit from simple trading and pricing throughout the trading day.

This is different from unlisted managed funds, where investors can only invest and withdraw directly with the fund manager based on a single daily price which investors do not know until the next day.

Comparison between ETF and a Listed Share

ETF Vs. Mutual Fund

Points of distinction between ETF and Mutual Fund

• Exchange-traded funds trade actively during trading hours, while mutual funds trade at closing NAV.
• Exchange-traded funds involve low operating expenses while operating expenses vary for mutual funds.
• There are no limits on the investment value for exchange-traded funds, while most mutual funds generally have minimum and maximum investment criteria.
• Exchange-traded funds are tax-efficient, while mutual funds are comparatively less tax-efficient.
• Unlike mutual fund investments that might involve sales loads, exchange-traded funds do not involve sales loads.

Comparison between ETFs and Mutual Funds

ETF Vs. Physical Gold

Physical gold is available in physical form with different levels of purity.

Gold has been a proven haven for many investors for centuries as it has performed well in all adverse periods, such as war or the global market. But how you invest in gold is very important. Investing in gold ETF is a  better option than investing in physical gold. Physical gold is best for immediate personal use, not for investment.

Advantages of Investing in Gold ETF than Physical Gold

• Buying Gold ETF is hassle-free compared to physical gold, with no risk on the purity of gold.
• Gold ETF has more liquidity. These funds are listed and traded on a stock exchange like common stocks. So, it could be bought and sold at any time of the day.
• Physical gold attracts various taxes like wealth tax and GST.
• No storage problem with Gold ETF. With physical gold, there is a risk of theft.
• Investors can place different types of orders for buying ETFs like stop-loss orders, buy on margin, etc., as they are traded like stocks in the market.

ETF Vs. Gold Mutual Fund

Gold ETF

A Gold ETF invests directly or indirectly in gold reserves. Investments are usually made in stocks of gold-producing and distributing companies, physical gold, and in stocks of mining companies. It is a convenient way to invest in an asset without purchasing the commodity in its physical form.

Gold Mutual Funds

Gold Mutual Funds is a variant of Gold ETFs. These are schemes that mainly invest in gold ETFs and other related assets. Gold Mutual Funds do not directly invest in physical gold but take the same position indirectly by Investing in Gold ETFs.

Comparison between Gold ETF and Gold Mutual Fund

ETF Benefits

Benefits of Investing in ETFs to Investors

• Lower fees: There is no sales load; however, brokerage commissions apply.
• Buy and sell any time of the day: Mutual funds, in contrast, settle after the market close.
• More tax efficiency: Investors have better control over when they pay capital gains tax.
• Trading transactions: Because they are traded like stocks, investors can place a variety of types of orders (limit orders, stop-loss orders, buy on margin) which is not possible with mutual funds.
• Allow investors to take advantage of the prevalent price; exchange-traded funds ensure purchases on the stock exchange and the ease of making intra-day sales at the existing price.
• Exchange-traded funds are an efficient and flexible investment instrument for immediate exposure to equity markets.

ETF Tax Benefits

Tax Treatment of ETFs

ETF investments are subject to taxes. However, tax rates on gains from ETF investments vary based on the fund’s underlying asset. If the underlying asset is a commodity such as gold, the taxation rules would be the same as in the case of profits generated from the sale or trade of non-equity MF 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.

Taxation of Equity-Based ETFs

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 or sale of ETF shares are considered short-term capital gains if the shares were held for less than one year from the date of allotment. As per current rules, short-term capital gains are taxed at the rate of 15% in the case of equity-oriented ETFs.

The long-term capital gains rule in the case of this type of ETF applies to shares that have been held for over a year from the date of allotment. As per current taxation rules, long-term capital gains in the case of equity-oriented investments are taxed at 10%.

Taxation of Non-Equity ETFs

Non-equity ETFs, such as gold ETFs, 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 or sale of ETF shares before the completion of 3 years from the date of investment.

Such profits are added to the investor’s annual income for the applicable year and taxed according to the applicable slab rate. Shares in ETFs held for over three years from the date of allotment are subject to long-term capital gains rules. Presently, non-equity-oriented ETFs, such as a Gold ETF, are taxed at 10% before indexation and 20% after indexation benefits.