How do ETFs work?
Fund managers of ETFs buy stocks of the benchmark indices to ensure that returns of the ETFs match index return. Similar to stocks, ETFs are also listed on stock exchanges and investors can invest in them or trade generally. There are buyers and sellers of ETFs and the price is determined according to the demand and supply. Every ETF is assigned a unique ISIN number and these ETFs can be held in one’s account exactly in the same way other shares and securities are held.
Categories of ETFs
There are 4 categories in which ETFs are available.
- Index ETFs that are benchmarked to the Nifty or the Sensex.
- Gold ETFs that are indexed to the market price of gold.
- Sectorial or thematic ETFs are benchmarked to a portfolio of stocks in the specific industry.
- International ETFs which invest in funds abroad. These are normally funds sponsored by their parent company based in another country.
Characteristics of ETFs
Let us discuss a few characteristics of ETFs:-
- ETFs are like shares that can be traded on the stock exchanges
- ETFs are one of the best modes to diversify your stock investments
- ETFs can be purchased and sold at any time of the day during the market hours.
- An ETFs expense ratio is generally lower than most traditional mutual funds
- If you buy an ETF that follows a sector or asset class, you receive exposure to a wider selection of assets which further strengthens your portfolio and helps in diversifying it.
ETFs, provide access to various alternative investment options like investing in commodities and international securities. They are a low-risk option as they replicate a stock index and offer diversification as compared to investing in independent stocks. They also offer liquidity and real-time settlement as they are listed on the stock exchange and are traded like stocks.
Risks associated with ETFs
ETFs are associated with stock markets so they are affected by market volatility
- Bid-ask spreads on ETFs could widen adding to your risk.
- There is a risk of tracking error which means that your ETF may not precisely reflect the result of the underlying index.
Tax Implications of ETFs*
Tax Implications for Index ETFs and Sectoral ETFs
Index ETFs and Sectorial ETFs are treated exactly like equity funds. It means that any gains will be classified as short-term capital gain if held for less than one year at a 15% tax rate and if they are held for more than one year, then it becomes a long-term capital gain and is completely tax-free in the hands of the investor.
Tax Implications for Gold ETFs and International ETFs
Gold ETFs and International ETFs are not treated as equity funds for taxation purposes. They are considered non-equity products. It means that it will be treated as short term gain if held for less than 3 years and if it is held for more than 3 years, it will be considered as long term capital gain and will be taxed at 10% of gains or 20% of indexed gains, whichever is lower.
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*Note- These details are for information only. Please contact your financial advisor/Chartered Accountant for further details on taxation.