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Understanding Exchange Traded Funds (ETFs) – Part 2/2

The first blog discussed the basic concepts about Exchange Traded Funds (ETFs). In this one, we will focus on the analysis parameters before investing, the due diligence concepts like premium & discount, liquidity factor and taxation impact.

Understanding the premiums and discounts

In our previous part, we mentioned the demand and supply that makes up the market price as the ETF trades real-time on the exchanges. While the prices of liquid ETFs trade in line with the net asset value (NAV) of the ETF most of the time, sometimes, particularly during volatile market phases, the price of an ETF can trade away from the NAV of the ETF. If the price of an ETF is above its NAV, it’s called a premium and if the price is below its NAV, it’s called a discount. Usually during volatile times the authorised participants (APs) and market makers make money. When there is a discount, the APs would buy the ETF units on the exchange and give them to the AMC. In return, the AMC will give the underlying shares of the ETF to the AP. APs would sell those in the market and make profit.

Liquidity Factor

When it comes to ETF liquidity, it is not like the normal liquidity we analyse in the stock market. There are different aspects of it. The secondary market, the market depth and the primary market liquidity. Retail investors buy and sell ETFs in the secondary market. But, the liquidity aspect of ETFs is beyond this. Primary liquidity is the other type of liquidity. Here funds are created or redeemed in predefined lot sizes in exchange for a predefined underlying portfolio basket. Allotment to the investors is after the underlying portfolio basket is deposited with the fund along with the cash component. The determinants of liquidity of both markets are different. In the secondary market, liquidity is the function of the value of ETFs shares traded. While in the primary market, liquidity is the function of the value of the underlying securities or shares.

The ETF choices in India are equity ETFs, debt ETFs and commodity ETFs. While the Equity has got two sub-categories, namely - plain vanilla market-cap weighted ETFs tracking indices and smart beta ETFs that target value, quality, momentum and low volatility. In the debt segment there are Government Securities (G-sec) ETFs, Bharat Bond ETF holding the PSUs and also Central Public Sector Enterprise (CPSE) ETFs. In commodities, there is only a Gold ETF. As for the management style of ETFs, not all are passive ones. The smart beta types are not the passive one.

For an investment horizon of fewer than three years, Gold ETFs attract short term capital gains (STCG). The gains are added to the total income of the investor and taxed according to the tax slab.

ETF Taxation in India

As the ETFs are traded it attracts Security Transaction Tax (STT), and the gains from investments are taxed. However, the ETFs are more tax-friendly than mutual funds. Even though both are subjected to capital gains tax and dividend taxes, the relative amount of fee charged on ETFs is much lower than the one levied on mutual funds.

Like for an investment horizon of less than one year, ETF investments attract STGC taxes of 15 per cent plus the 4 per cent CESS. In case of the long term investments (those above one year), the returns fall under long term capital gains (LTCG) taxes. Accordingly, attract 10 per cent tax on gains above Rs. 1,00,000.

However, the taxation varies for Gold ETFs and ETFs other than equity. Here, if the investment horizon is three years for LTCG, the tax rate is at 10 per cent without indexation and 20 per cent with indexation, whichever is beneficial for the investor. For an investment horizon of fewer than three years, Gold ETFs attract STCG. The gains are added to the total income of the investor and taxed according to the tax slab.

Who should invest?

If one is wondering whether they can invest or not, as of now it still looks like a convenient investment for HNIs and institutional players. But if retail investors want to invest they must look at the following factors before investing. The first and foremost factor is one must use the limit orders. Here one can decide the price at which one wants to buy. Basically, the bid and ask price spread is higher and hence it is better to opt for limit orders. Further, constantly watch the iNAV (indicative or intraday net asset value) as it is the real price parameter to understand the premium and discount. The trades should be taken when the prices settle down at the market opening. And lastly, look for the average one must analyse if the AMC is focused on the ETFs.

While it may not be applicable to all the AMCs, it is a fact that most of the AMCs offer ETFs but doesn’t mean they are serious about them. A few of the AMCs make significant tracking errors. The ETF is a low margin segment with HNIs and institutional players dominating volumes. Hence, many AMCs hardly focus on ETFs. By tracking the last few years records, one can easily find out if there are tracking errors made by the AMC. It is advisable to avoid such ETF investments.

  • One must look at the average volumes over a period of time and see how an ETF has traded.

  • Regularly traded and rightly tracked are the two important parameters here.

  • Sometimes there are ETFs that may witness a brief spike and then again the volumes dry up.

  • It is advisable to look at the average daily volumes.

  • Fortunately, slowly and steadily, average volumes witnessed a 15 per cent growth in CY20 over CY19. However, whether it is sustainable or not needs to be seen.

There are relative disadvantages like the requirement of brokerage fees and demat account. However, the process and cost now a day for the same have gone down significantly and hence, won’t be considered as a real disadvantage. Higher volatility is one disadvantage – But if the investors are ready to take a longer term bet and if the risk appetite approves, an ETF is a good opportunity.

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