What are the types benefits and limitations of ETFs

What are ETF Funds?

ETFs or Exchange Traded Funds are a basket of marketable securities tracking an underlying benchmark like NSE, BSE, Nifty 50 or even a commodity, theme or sector. ETFs encapsulates the features of different investment options like the mutual funds and stocks. Although they seem like index funds, the difference between ETF funds and index funds is that the former can be freely traded on the stock exchange while the latter cannot. ETFs are popularly known as passive mutual funds.

Types of ETFs

There are many types of ETFs available in the market today. Let us take a close look at them.

1. Equity ETF: These are exchange traded funds which work somewhat like you are investing in equity and in mutual funds. These funds have lower costs than active mutual funds and are of the following types.


1. Sector: Sector based ETFs invest in stocks of different companies belonging to a specific sector like pharma, banking etc.


2. Market capitalization: Based on the market capitalization of the stocks an ETF invests, it can divide into Large Cap, Mid cap and Small Cap.


3. Factor: Factor based ETFs are those that track indices depending on various factors like momentum, size, volatility, alpha etc.
2. Debt ETF: As the name implies, Debt ETFs invest in fixed income instruments like Government securities, G-Sec Bills, debentures, commercial papers, certificates of deposits etc. These ETFs provide stability and steady returns.


3. Liquid ETFs: These types of ETFs offer liquidity by investing in debt and money market securities with maturities of up to 91 days.


4. Index ETF: These are a common category of ETFs that track the performance of a benchmark like the Nifty 50, Sensex, BSE etc. The returns from these ETFs resemble the returns from the underlying benchmark they track.


5. Commodity ETF: These types of ETFs invest in assets like gold, silver, crude oil, platinum etc. The demand and supply fluctuations determine the NAV of these ETFs. The most regular type of Commodity ETF is the Gold ETF which represents the physical Gold which may be in dematerialized form. One Gold ETF unit is equivalent to 1 gram of physical gold of high purity.


6. International ETF: This type of ETF offers investors the facility of buying a basket of international stocks. It resembles country specific market index or any global market index.

How to invest in an ETF?

For investing in an ETF, you need to have a trading account just like you would if you were trading in stocks. Once you identify the ETF you want to invest in, you can place the order on your online trading platform itself, by specifying how many units of the ETF you want to buy.

For example, to buy gold ETF, you can buy 1 unit of ETF signifying 1 gram of gold at the prevailing market price. The ETF price will keep fluctuating throughout the day with the gold price.

Once you buy the ETF, the units get credited into your demat account on the T+1 day. Similarly, when you sell the ETF, the proceeds are credited into your bank account on the T+1 day settlement.

Benefits of investing in an ETF

1. Low-cost investment: ETFs are passive funds and hence, they are not actively managed by fund managers. This results in minimum operational costs or expenses, leading to higher returns compared to other investment options like a mutual fund.


2. Diversification: ETFs provide the benefit of investing directly into the underlying stocks with the benefit of a diversified portfolio. If you were to invest in a single stock, the risks associated would be much higher than if you invest in Nifty 50 ETF that includes in it the topmost 50 companies listed in the stock exchange. This makes investment into ETFs less risky than investment into a single stock.


3. Liquidity: This is an important benefit of investment into ETF as there is no exit load levied on ETF while selling, regardless of when you bought it. ETFs can be freely bought and sold at the stock exchanges, making it easier to book profits in up markets.


4. Simplicity: The investment into ETF does not require elaborate preparations like researching AMC performance, Fund manager’s expertise, or past performance. The nature of ETF is that it tracks the performance of the securities they represent and hence offers you returns that resemble the underlying assets.


5. Tax benefits: The short term and long term returns from ETFs are treated in the same way as Equity or Non equity taxation of mutual funds. This means that in equity taxation, short term capital gains (holding period of the investments for less than 1 year) are taxed at 15% (plus applicable surcharge and cess). Long term capital gains (holding period of more than 1 year) are tax exempt up to Rs 1 lakh in a financial year and taxed at 10% (plus applicable surcharge and cess) thereafter. In non-equity taxation (applicable for debt, commodities and international ETFs), capital gains (irrespective of holding period) are added to the investor’s income and taxed as per the tax rate of the investor.

Limitations of ETFs

1. You cannot start a systematic investment plan in ETF, which is an attractive and convenient way of investing in mutual funds.


2. Even though investing in ETF incurs lesser costs when compared to investments into mutual funds, ETFs can prove to be more expensive if compared to investing into a single stock on the stock exchange. However, in that case the associated risk will also increase manifold.

The Bottom line

Comparing the benefits of investing in ETFs vis-à-vis their limitations, it is quite evident that the benefits far outweigh the disadvantages. You may start diversifying your portfolio to include exchange traded funds. However, you must check with your financial advisor which ETFs would be suitable for your portfolio basis your risk taking appetite and investment time horizon.