ETF funds: 4 things to know before investing

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First launched in the USA in 1993, exchange traded funds found their way to the Indian investment industry in the year 2002. If has been close to two decades ever since ETFs were introduced to retail investors and over the years, they have become one of the most sought after investment schemes. Not just in India, ETFs are popular across global investment markets with a lot of investors trying to gain understanding of the market vagaries through investments in these market linked schemes. They can be traded just like any other company stock determined by is live market price. 

What is an ETF?

Exchange traded funds , abbreviated as ETF, is an open ended mutual fund scheme that aims at generating capital appreciation by replicating the performance of its underlying securities that belong to a particular index, benchmark, asset class, sector, industry etc. Just like any other mutual fund scheme, it pools financial resources from investors sharing a common investment objective and invests the capital raised in a diversified portfolio of securities. An ETF may invest in stocks, bonds, commodities, currencies, international securities etc. It all depends on the fund manager and what the scheme wants to achieve through its asset allocation strategy. Although ETFs function just like index mutual funds, they can be live traded at the stock exchange whereas one can only request the fund manager to buy or sell their index fund units.

4 Things to know before investing in exchange traded funds

ETF categories

As of now there are 4 type of ETF funds available for investing here in India –

  • Equity ETFs – These are exchange traded funds that mimic the performance of stocks belonging to a particular index or industry with minimum tracking error. 
  • Gold ETFs – Gold has been used as a hedge against market fluctuations and inflation. Gold ETFs are an excellent alternative for those seeking investments in gold minus the hassles of owning gold in physical. Through gold ETFs, investors can invest in gold as an asset class without having to purchase gold in physical form.
  • Debt ETFs – These invest in bonds and other fixed income securities for generating capital gains.
  • International ETFs – As the name suggests, the funds may invest across global markets and give investors exposure to the international securities.

ETFs offer passive fund management

Exchange traded funds invest in a diversified portfolio of securities; however, the fund manager doesn’t actively trade these securities. ETFs follow a passive fund management strategy and are designed to mimic the performance of their underlying index with minimum tracking error. ETFs give investors a chance to enter and exit the market throughout the day unlike mutual funds which can be only be traded once a day. Passive funds do not have a management team to take investment initiatives which is why it has very little involvement of human emotion.

ETFs offer liquidity

Unlike some mutual funds like ELSS which come with a statutory lock-in period, ETFs do not have any lock-in period. Investors can buy or sell their ETF units any time during the trading hours. This makes exchange traded funds highly liquid than other mutual fund schemes whose units can be brought or sold by informing the AMC only once that in a day.

Taxed depending on the underlying asset class

Equity ETFs are taxed as per tax implications levied on equity mutual funds. However, tax implications on international ETFs are slightly different than normal equity ETFs. Gold and other non-equity ETF gains are treated as per the tax implications levied on capital gains earned through investment in debt mutual funds.