Things to know before investing in ETFs

For Indian investors, the concept of investing in equities internationally has become popular in recent years. Earlier, investing overseas was restricted to a few large fund houses only. And investors allocated their funds to stocks, gold, real estate, and mutual funds online. There weren’t many who had the knowledge and willingness to invest in Exchange Traded Funds (ETFs).

Mutual funds are still the most popular route to start investing. A mutual fund is a professionally managed investment fund that accumulates funds from investors and uses the proceeds to buy bonds or stocks. Asset Management Companies (AMC) are responsible for managing mutual funds, and it is the manager’s goal to outperform the benchmark.

ETFs are an alternative to mutual funds. If you don’t know yet, an Exchange Traded Fund (ETF) is a type of investment traded on the stock exchange. You can buy or sell an ETF throughout the day as the price fluctuates, similar to stocks.

Here are 4 things you need to know about ETFs before investing in the instrument:

1. ETFs are cost-efficient

With ETFs, you can easily gain exposure to many companies without paying high trading fees. Instead of buying shares of 500 different companies, an investor can invest in the top 500 US companies by buying a share of the SPX, an ETF for the S&P 500 index. The expense ratio of ETFs is low compared to an actively managed fund. An actively managed fund charges a fee for the fund manager’s expertise. Conversely, there are no such charges for passively managed ETFs. As a result, you have more money invested to generate higher returns.

2. ETFs help in diversification

If you want to diversify your portfolio, ETFs are a great choice. The purchase of a single ETF lets you invest in hundreds of bonds or stocks or diversify your portfolio across sectors. A Systematic Investment Plan (SIP) in ETFs helps you average the cost of purchase and accumulate wealth over a long period.

3. ETFs are taxable

The tax implications on all ETFs aren’t the same. If you hold ETFs for more than a year, the capital gains you earn due to an increase in the value of the asset is a long-term capital gain (LTCG). There is no tax on LTCG up to Rs 1 lakh in a financial year. The earnings above this limit are taxed at 10%. For ETFs you hold for less than a year, taxes are charged on short-term capital gains at 15%.

4. Tracking error

The actual returns of the fund may be different from the returns of the benchmark index it has its underlying stocks in. This difference is known as tracking error. An ETF with lesser tracking error will have better performance.

Takeaways

Exchange-traded funds (ETFs) are a popular form of passive investing. You must understand the fundamental nature of ETFs and their risk-return characteristics if you want to avoid potential pitfalls. You must also monitor their cost and tracking error before investing. The Tata Capital Moneyfy App provides all the tools you require to plan your investments and achieve your financial goals.