ETF Investing for Beginners: A Comprehensive Guide
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Introduction to ETFs
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Exchange Traded Funds (ETFs) have become a significant force in the investment world. Globally, ETFs manage almost $11.5 trillion as of 2023. In India, ETFs were introduced in 2002 but gained traction post-2013. This article will explore the basics of ETFs, their benefits, drawbacks, and how they compare to mutual funds.
What is an ETF?
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An ETF is a tradable security that tracks an index, bond, commodity, or a basket of assets. The key elements are:
* Tracking an index
* Tradability on exchanges
For instance, a Nifty 50 index ETF mirrors the Nifty 50 index performance. Similarly, a gold ETF’s value is closely linked to gold prices. ETFs offer both trackability and tradability, making them versatile investment tools.
Benefits of ETFs
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ETFs offer several advantages that have contributed to their global popularity. Let's delve into these benefits:
### 1. Simplicity and Transparency
ETFs are straightforward to understand, offering diversification and transparency. They disclose holdings daily, and their prices are available in real-time. This makes ETFs accessible to even novice investors.
### 2. Tradability
ETFs can be bought and sold on stock exchanges during trading hours. This provides real-time NAVs and allows investors to react quickly to market movements.
### 3. Wide Range of Choices
Indian investors have nearly 200 ETFs to choose from, covering broad markets, sectors, commodities, and international indices. This diversity allows for a well-rounded investment portfolio.
### 4. Low Expense Ratios
ETFs generally have lower expense ratios compared to mutual funds. Some ETFs have expense ratios as low as 0.0279%, significantly reducing the cost of investment.
Concerns and Drawbacks of ETFs
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Despite their benefits, ETFs have some drawbacks that investors should be aware of:
### 1. Incidental Costs
While ETFs have low expense ratios, other costs like broker commissions, demat charges, STT, SEBI fees, stamp duty, GST, and bid-ask spreads can add up. It’s essential to consider these total expenses.
### 2. Liquidity Issues
Liquidity can be a concern with some ETFs, especially those with low trading volumes. Low liquidity can make it difficult to buy or sell ETFs at desired prices, affecting overall returns.
### 3. Tracking Error
Tracking error is the deviation between an ETF's performance and its underlying index. Factors such as delays in transactions, cash holdings, and expense ratios contribute to tracking error. Lower tracking errors are more desirable.
### 4. Impact Cost
Impact cost refers to the cost incurred due to the size of an order relative to the security's liquidity. Higher impact costs can reduce total returns, especially for large trades in less liquid ETFs.
ETFs vs. Mutual Funds
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ETFs and mutual funds, particularly index funds, share similarities but also have key differences:
### 1. Impact of Inflows and Outflows
In ETFs, buying or selling shares does not directly impact other unitholders. The number of shares adjusts accordingly. In index funds, inflows and outflows affect all investors as the fund buys or sells underlying securities.
### 2. Tradability
ETFs are traded on stock exchanges, allowing real-time transactions. Index funds are not tradable in real-time and require a demat account for ETF transactions.
### 3. Expense Ratios
ETFs generally have lower expense ratios compared to index funds. However, additional costs like STT, demat charges, and GST should be considered.
### 4. Liquidity
Liquidity is not an issue for index funds as the fund house honors all buy and sell orders. ETFs, however, may face liquidity constraints, especially for less traded ETFs.
How to Invest in ETFs
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Investing in ETFs is straightforward and requires a few steps:
### 1. Open a Trading and Demat Account
Choose a broker like Zerodha, ICICI Direct, mStock, Groww, or Upstox. Open a demat account with NSDL or CDSL to hold ETF units.
### 2. Search and Select ETFs
Use the trading platform to search for ETFs by their symbols. For example, to invest in a Nifty 50 ETF, type "Nifty" in the search bar and select the desired ETF.
### 3. Check Volumes and Orders
Examine the volumes and orders to assess liquidity. This helps in making informed decisions about buying or selling ETF units.
### 4. Execute the Trade
Enter the number of units you wish to buy or sell, confirm the order, and the transaction will be executed. The units will be credited to your demat account by the next day.
Application of Dividends in ETFs
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ETFs reinvest dividends received from the shares they hold back into the scheme. This helps in minimizing tracking errors. In exceptional cases, dividends may be credited to investors.
ETF Taxation
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ETF returns can be classified into two types: dividend income and capital gains.
### 1. Dividend Income
Dividends received from ETFs are added to the investor's annual income and taxed according to the income tax slab.
### 2. Capital Gains
Capital gains taxation depends on the asset class and holding period:
* Equity ETFs: Short-term gains (held < 12 months) taxed at 15%, long-term gains (> 12 months) above ₹1 lakh taxed at 10%.
* Non-equity ETFs: Taxed as per income tax slab post-April 2023 amendment.
* Asset Allocation ETFs: Long-term gains (> 36 months) taxed at 20% with indexation benefits.
Conclusion
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ETFs offer a versatile and cost-effective way to diversify investments. While they have some drawbacks, understanding these can help investors make informed decisions. By considering factors like expense ratios, liquidity, tracking error, and impact cost, investors can effectively use ETFs to achieve their financial goals.
We hope this guide has provided a comprehensive overview of ETFs. Please share your thoughts and any topic ideas for future articles in the comments below. Happy investing!
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