Exchange traded funds: Know how to select the right ETF

Retail investors are increasingly investing in exchange traded funds (ETFs) because of low costs and returns mirroring an index. Assets under management of passive funds touched Rs 5.2 trillion in March this year, a growth of over 2.5 times in the last two years. Of this, Rs 4.1 trillion alone is contributed by ETFs.

Investors need to look at various factors before choosing the right ETF. For one, they should opt for the one which has high trading volumes and good liquidity. Next, they should look at the expense ratio and the tracking error.

Select the right ETF
Investors need to look at the asset class they want to invest as ETFs offer exposure to equity, debt, commodities and global equities. Once the investor has zeroed in on the asset class, say, equity, he needs to identify which index—large cap indexes such as Nifty and Sensex or sectoral indices such as banking or technology—within equity that he wants to get access to. Ashwin Patni, head, Products & Alternatives, Axis Mutual Fund, says once the investor has identified the index, he will see that there is also a lot of choice in terms of multiple fund managers that may be offering an ETF for that particular index. “So depending on which fund house they want to go with they can then invest in the particular ETF,” he says.

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

Consider ETF liquidity
Retail investors must consider the liquidity while selecting the ETF. In fact, in case of big-ticket investments which are generally made by institutional investors, they can get liquidity from the asset management companies directly. But retail investors who will be making small investments can face high liquidity issues in ETFs having low trading volumes. So, it will become difficult for them to sell or get fair market price for their holdings.

Higher impact cost
Lack of liquidity can lead to a higher impact cost. For strategies that lack the minimum liquidity, there is a risk that investors’ trade gets executed at a price that is meaningfully away from the prevailing net asset value. “Therefore, it is important to check for minimum liquidity levels when trading. Investors can also try taking a few smaller trades or positions initially to get comfortable with the trading volumes since in some cases the liquidity may be latent because of the presence of market makers,” says Patni.

In the Indian market, there are very few institutional investors who participate in the ETF space. Also, it is not a very active market for retail investors. “This situation will definitely lead to higher impact cost for retail investors wherein they will have to bear high transaction costs due to low liquidity and will not be able to transact at fair price,” says Kothari. He suggests retail investors should go with Index Funds instead of ETFs where they will not have to worry about liquidity and can sell anytime as per their needs.

Tax implication
The tax structure differs according to the nature of capital gains—long-term or short-term. For equity ETFs, capital gains are considered as short term if the holding period is less than a year. If the holding period is more than one year, then it will be considered as long term. Under Section 112A of the Income Tax Act, long-term capital gains up to Rs 1 lakh is exempt from tax and any gain over Rs 1 lakh is taxable at 10% without indexation benefit. Short-term capital gains are taxed at 15% under Section 111A. Dividends received from ETFs are taxable at the applicable slab rate. Moreover, ETFs are liable to withhold tax at source at 10% in case of residents and 20% for NRI (subject to provisions of DTAA).

For other ETFs like gold or silver, the holding period is three years for classification of long-term gains. 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 for investing in an ETF as 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 can face liquidity issues in ETFs having low trading volumes, thus leading to higher impact cost
Index Funds are better as you do not have to worry about liquidity and can sell anytime
There are no real tax benefits in ETFs as compared to other investment options such as mutual funds

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