What are Exchange Traded Funds (ETFs)?

Exchange Traded Funds are mutual fund schemes that typically mimic/track their underlying benchmark index, sector, commodity, or other assets. Unlike traditional mutual funds, ETFs can be bought and sold on the exchange the same way that regular shares can be traded on the exchange.

FAQs for ETF

There are 5 types of ETFs in India - Equity, Debt, Gold, Global and Smart beta

  • Equity ETFs are passive investment instruments that are based on indices and invest in securities in the same proportion as the underlying index.
  • Debt ETFs like equity ETFs offer exposure to a basket of securities that, in this case, is a basket of bonds and other debt products.
  • Gold ETFs are instruments that are based on gold prices and invest in gold bullion. Because of its direct gold pricing, there is complete transparency in the holdings of an ETF.
  • Global ETFs invest mainly in foreign-based securities. These ETFs may track global markets or track a country-specific benchmark index.
  • Smart Beta ETFs comprise a list of stocks that are selected based on criteria. The criteria is often a factor or a combination of factors like low volatility, value, quality or momentum. For example, a Nifty Smart Beta ETF with a focus on low volatility would comprise stocks within the 50-stock index that are relatively less volatile than their peers.
Feature ETFs Securities Traditional Mutual Fund
Real-time trading and pricing during market hours
Convenience of putting limit orders
Ability to be traded real-time on the Stock Exchange
Arbitrage between Futures and Cash Market
Diversification possible with a single unit
Returns in sync with the market/ benchmark index *
Intra-day trading
Exit Load
*Returns are subject to Tracking Error
  • AUM (Assets Under Management): Size of the ETF scheme is a very important factor while selecting any ETF, because larger AUM (Assets under Management) indicates sufficient liquidity in the scheme.
  • Cost: Total Expense Ratio (TER) and transaction costs incurred by ETF schemes should be comparatively lower, as higher TER can lead to Tracking Error which may eventually diminish the returns of the fund.
  • Tracking Error: Lower and consistent Tracking Errors indicate the efficiency of the ETF. Tracking Error (TE) of ETF scheme indicates the deviation of performance of the fund from its’ underlying benchmark. For ex: If the benchmark is returning 9.2% at the similar instance if the ETF mimicking/tracking this benchmark returns 9.1% that means the Tracking Error of the fund is 0.1%. No fund can exactly replicate the performance of its’ underlying benchmark, there shall be some difference in returns that would always arise due to TER, Cash Component and other factors.
  • Bid/Ask Spread: The main factor that has to be considered while actual buying and selling of ETF units is the Bid/Ask spread on the exchange. The trading prices of the units of ETF have to be close to the real time NAV (iNAV) of the ETFs. Spreads on the Buy and Sell side indicate inefficient liquidity.
  • Liquidity: Liquidity of an ETF indicates the market depth of any ETF. It is the ease at which ETF units can be bought and sold on the exchange. Higher liquidity in an ETF indicates its’ higher potential of getting bought and sold efficiently in the required time frame or at the desired price.

The tax on redemption of equity ETFs depends on holding period. If the holding period is more than a year, then there is long-term capital gain. It is exempt if the gain is up to Rs.1 lakh. For long-term capital gain of above Rs.1 lakh, the tax liability is 10% without indexation benefits. However, if the holding period is less than 12 months, then 15% tax liability arises from short-term capital gain.

In ETF (other than equity) and FOF, if the holding period is less than 36 months, there is short-term capital gain. Income from such sales is included in the normal income, and tax is calculated as per normal slab rates. Also, the tax liability of 20% (with indexation benefits) is calculated if long-term capital gain arises from selling such assets. The FOFs are treated as debt funds regardless of any of the schemes they invest in.

While ETFs have a low expense ratio, they do have some charges that are specific to them. Because ETFs, like stocks, are purchased as shares through a broker, an investor must pay a brokerage commission each time he or she makes a purchase. In addition, an investor may incur the standard fees of stock trading, such as disparities in the ask-bid spread and so on. Traditional mutual fund investors, on the other hand, are indirectly susceptible to the same trading charges because the fund pays for them.

ETFs have specific risks in spite of their diversification benefits. Generally, the risk associated with investing in ETFs are broadly classified into:

  • Risk related to the Market: ETFs are exposed to market risks like stock and other mutual funds in spite of their diversification benefits. The broader the index that an ETF tracks, the lesser will be its’ market risk, but it can’t be completely eliminated.
  • Liquidity risk: ETF liquidity has two components – first is the volume of ETF units traded on the exchange and the liquidity of the individual securities in the portfolio. The counter of ETF may tend to have a higher bid-ask spread in case of volatility in the market. Similarly, any security with insufficient liquidity in the portfolio of the index may also lead to inefficient tracking which in turn leads to differences in returns.
  • Portfolio Risk: There are many kinds of ETFs available in the market including international and exotic ETFs. Hence, selecting the right ETF to meet investors’ needs is the key to avoiding risks associated with the portfolio. Portfolio risk could be additionally topped with Currency Risk, Counter-Party risk, Geo-Political risk, and sector-specific risks.
  • Risk related to structure: ETFs can have different structures depending on what they invest in and how they distribute the capital gains from the portfolio. This can affect the tax liability of the investor. For example, ETFs using in-kind exchanges do not distribute capital gains to end investors while ETFs involving derivatives or commodities may have complex structures and tax implications. ETFs also face Tracking Error i.e. their return will deviate from the return of the underlying index because an ETF incurs certain expenses that the index doesn’t face.
  • Login to kotaksecurities.com   or “Kotak Stock Trader” Mobile App
  • Search for ETFs from the search bar (similar to stock/scrip search)
  • Select ETF to invest in
  • Place Order - buy/sell
  • User will be redirected to equity order placement page where you need to enter details like Price, Quantity and other details to submit the order
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