Tread carefully the rewarding ETF path

Jun 13 2014, 02:51 IST
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SummaryThe units are traded like that of a stock, but it operates like a mutual fund (MF).

An exchange-traded fund (ETF) allows investors to operate with a directional view on the market. The units are traded like that of a stock, but it operates like a mutual fund (MF). ETFs provide investors with a mix of diversification and professional management available for MFs, along with the ability to trade these units instantly on a daily, weekly or monthly basis. Active investors are more comfortable with ETFs as their prices are more volatile than that of index MFs.

Trading of units

The buying and selling of ETF units is done through a demat account, for which investors have to pay broker commissions and other charges. Investing in and redemption of MF units, on the other hand, can be done through an investment advisor. One should choose an ETF based on its trading volume and liquidity. The higher the trading volume, the greater the liquidity usually. Choose ETFs that have shown good historical returns for reasonable fees — check the ETFs offered by various fund houses and compare them to pick the best. It might be cheaper to buy an ETF compared to an MF as transaction costs are lower.

Taxation

ETFs and MFs are taxed similarly as they are both equity investments. There is a 10% capital gains tax on short-term investments (less than one year) and no tax on long-term investments (over a year). However, ETFs are subject to other taxes — such as STT and service tax — since they are traded on stock markets.

Price volatility

The price of an index ETF fluctuates throughout the trading day, making it more volatile than a regular index MF.

However, if you invest in an index ETF for the long term, price volatility is unlikely to have a substantial impact on your investment.

Diversification

Like MFs, ETFs also provide a diversified route to invest in stocks (be it a specific sector, theme, or the broader market as a whole), bonds and commodities. So, instead of investing in a particular set of portfolio stocks, choose the ETF route to diversify at a lower cost.

Note that ETFs, like stocks, can be easily bought or sold at any point in the stock market but each time you trade you must pay brokerage. So, it is important to know the brokerage and other transaction costs.

Schemes

In ETFs, one can either choose the dividend (only payout) or growth option; there is no automatic dividend reinvestment option. Dividends are paid to

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