Traded index funds: how to select the right ETF

Retail investors are increasingly investing in exchange-traded funds (ETFs) due to low costs and index-like returns. Assets under management of passive funds reached 5.2 trillion rupees in March this year, growing more than 2.5 times over the past two years. Of this amount, only Rs 4.1 trillion comes from ETFs.

Investors should consider various factors before choosing the right ETF. On the one hand, they should go for the one that has high trading volumes and good liquidity. Next, they need to look at the expense ratio and the tracking error.

Select the right ETF
Investors should consider the asset class they wish to invest in, as ETFs offer exposure to equities, debt, commodities and global equities. Once the investor has focused on the asset class, say stocks, they need to identify which index – large cap indices such as Nifty and Sensex or sector indices such as banking or technology – within the actions he wishes to have access. Ashwin Patni, Head, Products and Alternatives, Axis Mutual Fund, says that once the investor has identified the index, they will see that there is also plenty of choice in terms of multiple fund managers who can offer a ETF for that particular index. “So depending on which fund company they want to go with, they can then invest in the particular ETF,” he says.

Manish Kothari, co-founder and CEO of Zfunds, a mutual fund distribution platform, says the first metric should always be volumes because even if an ETF is good in terms of expense ratio and tracking error followed, the high transaction costs of an illiquid security will negate these positive scores.

Consider the liquidity of ETFs
Retail investors should consider liquidity when selecting the ETF. Indeed, in the case of large investments which are generally made by institutional investors, they can obtain cash directly from asset management companies. But retail investors who will make small investments may face high liquidity issues in ETFs with low trading volumes. Thus, it will become difficult for them to sell or get the fair market price for their holdings.

Higher impact cost
Lack of liquidity can lead to a higher impact cost. For strategies that lack minimum liquidity, there is a risk that investor trades will be executed at a price that is significantly off the prevailing net asset value. “Therefore, it is important to check the minimum liquidity levels when trading. Investors may also try to take a few smaller trades or positions initially to familiarize themselves with trading volumes, as in some cases liquidity can be latent due to the presence of market makers,” says Patni.

In the Indian market, there are very few institutional investors who participate in the ETF space. Moreover, it is not a very active market for retail investors. “This situation will certainly lead to higher impact costs for retail investors, as they will have to bear high transaction costs due to low liquidity and will not be able to trade at a fair price,” says Kothari. He suggests retail investors opt for index funds instead of ETFs, where they won’t have to worry about liquidity and can sell whenever they need.

Tax implications
The tax structure differs depending on the nature of the capital gains, long-term or short-term. For equity ETFs, capital gains are considered short-term if the holding period is less than one year. If the holding period is longer than one year, it will be considered long-term. Under Section 112A of the Income Tax Act, long term capital gains up to Rs 1 lakh are exempt from tax and any gain over Rs 1 lakh is taxable at 10% tax free. indexing advantage. Short-term capital gains are taxed at 15% under Section 111A. Dividends received from ETFs are taxable at the applicable rate for the tranches. In addition, ETFs are subject to withholding tax of 10% for residents and 20% for NRIs (subject to the provisions of the DTAA).

For other ETFs like gold or silver, the holding period is three years for the long-term gain classification. Long-term gains are taxable at 20% with indexation benefits and short-term gains are taxable at applicable slab rates. Neeraj Agarwala, Partner, Nangia Andersen LLP, says there are no real tax advantages to investing in an ETF compared to other investment options such as mutual funds.

Decide on asset class, index and fund manager – in that order – when selecting an ETF
Retail investors may face liquidity issues in ETFs with low trading volumes, resulting in higher impact cost
Index funds are better because you don’t have to worry about liquidity and can sell at any time
There are no real tax advantages in ETFs compared to other investment options such as mutual funds

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