Finding the best ETF is daunting especially when one is spoiled for choice. Take any sector and you'll find as many as 50 large-cap value ETFs - and hundreds of them across all parameters. Also, many large-cap value ETFs have significantly varied portfolios, raising radically-differing investment implications. So, what are ETFs exactly? And, how do you choose from so many?
ETFs are a basket of stocks that reflect the composition of an index such as the S&P CNX Nifty or the BSE Sensex. They are essentially mutual-fund schemes or "index" funds, listed and traded, as are stocks, on the exchanges. They are priced continually and can be bought and sold throughout the trading day unlike mutual funds, the prices of which are based on the NAV (net asset value) at the end of a trading day.
Certain unique features of ETFs are that they can be bought and sold just like shares at real-time prices. These funds also promise delivery into your demat account. Since the minimum trading lot for ETFs is 1 unit, they can easily be bought and sold. ETFs help to diversify a portfolio as they mirror market indices. They also help in tax savings while providing arbitrage between the futures and the cash markets.
Generally, when investing, people tend to compare ETFs with mutual funds. There are, however, certain advantages when it comes to investing in ETFs over investing in mutual funds. First and foremost, ETFs can be purchased and sold online and "limit" orders are possible; mutual funds require paper-based investing and "limit" orders are not allowed. Also, arbitrage is possible in ETFs; mutual funds lack arbitrage opportunities. Intra-day trading is possible in ETFs, not with mutual funds, and no exit loads are applicable on ETFs as they are on mutual funds.
Broadly, two kinds of ETFs exist: gold ETFs and Index ETFs. Let us see when one should invest in ETFs.
Use Gold ETFS only for diversification
Gold is one of the most important asset classes, serving as a hedge against inflation. But investment in gold attracts taxation (wealth tax on an asset and capital-gains tax on disposal). Gold ETFs serve as a catalyst for investing in gold and savings in tax. Some major tax advantages of investing in gold ETFs are no wealth tax and no liable Securities-Transaction Tax, unlike shares which attract the STT. On gold in physical form purchased from banks or jewellers, sales tax or VAT is levied; on gold ETFS, none. To qualify for long-term capital gains, gold in physical form needs to be held for more than three years; with gold ETFs, holding them for a year suffices.
Certain other advantages of investing in gold ETFs are that the fear of theft is alleviated, and storage problems are non-existent as gold ETFs are in electronic form ("de-materialised"). Also, they are easy to sell online, and the proceeds obtained within two days. Even half (1/2) a gramme of gold can be bought online apart from 1 gram gold ETF units.
Internationally, gold is going through a slump as the U.S. economy recovers. So, the metal is best avoided. However, a certain basic amount to be allocated to the yellow metal for the purpose of diversification.
ETFs help, to a large extent, reduce the confusion-and anxiety-in deciding on a particular stock in a particular sector.
ETFs are the best option for investing in an index. They can broadly be classified into sector, money-market, gold and global indices. Also, similar to gold ETFs, investment in index ETFs sport their own tax benefits, apart from those already offered by gold ETFs. First, as with shares, tax is applicable at 15 per cent on the sale of ETFs if held for less than a year. If they are held for longer than that, no tax arises on their sale.
Liquid Bees ETFs (based on money markets) fetch higher returns than savings accounts, and no Tax Deduction at Source is applicable, unlike with interest on FDs.
Other advantages of investing in ETFs are the fact that ETFs can be held in electronic form (dematted). Sector-specific investing can be done through ETFs, for instance, in the banking sector, in the public sector, in infrastructure, textiles, capital goods, and so on. One can also invest in global markets such as Hong Kong and USA through ETFs. They prove useful for hedging since they can be borrowed and sold short. ETFs trade relative to most derivative contracts and provide a more accurate risk-exposure match. They can be used for arbitrage between the cash and futures markets, and can also cover option strategies on an index.
Purchasing an ETF without examining its holdings is like buying a stock without questioning the business of the company. Therefore, a background check on the holdings of an ETF is necessary since an ETF's performance is only as good as performances of its holdings.
The author is Director, WealthRays Securities