ETFs are similar to mutual funds but belong to a separate category, marked by distinct differences within the overall mutual fund classification.
Imagine you love different types of candies and want a bit of everything without spending too much on each kind. So, you decide to buy a ‘Candy Mix’ bag. This bag contains a variety of candies like chocolates, gummies, polos and many more. So, instead of purchasing each candy separately, you get them all in one bag.
An Exchange Traded Fund (ETF) is like that ‘Candy Mix’ bag, but it contains equities or bonds that track an underlying index.
ETF allows you to invest in various securities at once, and track indexes such as Sensex or Nifty. So, if you buy units of an ETF, you’re basically getting a small piece of share of several companies all at once, just like getting a taste of different candies from your mix bag.
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ETF can be bought to have ownership in the securities of Indian companies or foreign companies. For example, there’s an ETF called Mirae Assent FANG or MAFANG, which invests in the top 10 US technology companies, which include stocks of Facebook, Apple, Amazon, Google, etc. So, if you buy a unit of MAFANG ETF, you’re basically investing in these US companies at once, spreading your risk.
Also Read: Small Cap vs Mid Cap vs Large Cap Stocks: Where to invest for maximizing your returns?
Similarly, if you are bullish that Artificial Intelligence (AI) is the next big thing or a general-purpose technology that can create fortunes, but you are not sure which company you should place a bet on. In this case, IT ETFs can help you. If one company cannot achieve big in AI, it might not affect your investment as much if some other company in that ETF does well.
In summary, an ETF is like a mixed bag of securities you can buy and sell on the stock market. It’s a way to invest in various companies without buying each stock individually.
Types of ETFs
ETFs in India can broadly be classified into the following two categories:
- Equity ETFs
Equity ETFs mimic stock market indexes by holding representative securities. Some invest 100% in index securities, while others allocate 5-20% to alternative holdings.
- Non-equity ETFs
Non-equity ETFs include Debt ETFs, Gold/Silver ETFs and International ETFs.
As the name suggests, debt ETFs offer exposure to a collection of securities, specifically bonds and other debt instruments. Gold/Silver ETFs invest in gold and silver bullion, with their value linked to metal prices. International ETFs invest mainly in foreign-based securities (Hang Seng or NASDAQ).
How are ETFs different from mutual funds?
Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 recognises exchange-traded funds (ETFs) as mutual fund schemes.
As per Regulation 2(1)(jb) of the MF Regulations, “exchange-traded fund” means a mutual fund scheme that invests in securities in the same proportion as an index of securities and the units of the exchange-traded fund are mandatorily listed and traded on the exchange platform.
Thus, ETFs are similar to mutual funds but belong to a separate category, marked by distinct differences within the overall mutual fund classification.
Under Mutual Funds, a team of experts decide where to invest your money. These experts, called fund managers, study the market and use their judgment to pick the best investments, like stocks or bonds, aiming to make more profit for you. Whereas ETFs are like investment baskets that follow a specific list of stocks. They don’t involve a manager actively choosing which stock to include in the basket.
Further, ETFs are bought and sold on the stock exchange like regular stocks. On the other hand, mutual funds can be purchased or sold only at the day’s end NAV.
Tax treatment of earnings from ETFs
Investors can receive income from ETFs in two primary forms: dividends and capital gains. The dividends earned from ETFs are taxed in the hands of the investors at the applicable tax rates.
Taxable capital gains arise when units of ETFs are sold or redeemed. The tax rate to be charged on the capital gains depends on the type of ETF and the duration of its holding.
If the Equity ETF is sold after holding for 12 months or less, the resultant gain will be treated as short-term capital gains.
In the case of non-equity ETFs (including ETFs of shares of foreign companies), the gain is always deemed as ‘short-term’ irrespective of the period of holding. This special treatment has been introduced under Section 50AA of the Income-tax Act with effect from 01-04-2023. Section 50AA provides that any gain arising from the transfer of a unit of specified mutual funds (which invest not more than 35% of its total proceeds in the equity shares of domestic companies) or marked-linked debentures is treated as short-term capital gains.
Accordingly, the gain arising from such ETFs would be deemed as short-term capital gains irrespective of period of holding, and it shall be taxable at the rate applicable to the assessee. It should be noted that Section 50AA applies only to those ETFs that are acquired on or after 01-04-2023. This means the ETFs acquired on or before 31-03-2023 but transferred on or after 01-04-2023 will be subject to taxation as per the normal provisions.
In the case of a balanced ETF or asset allocation ETF, which invests more than 35% but less than 65% in the equity shares of the domestic company, the capital gains arising from the transfer of such ETF will be taxable as per the general provision. Such ETFs are considered long-term capital assets if held for more than 36 months before the date of transfer. These long-term capital gains are taxable at the rate of 20% after indexation of the cost of acquisition.
When calculating capital gains, the investor can deduct the cost of acquisition and expenses incurred wholly and exclusively in connection with the transfer of the ETF.
The tax rates on capital gains on the sale of ETF are tabled below.
(By CA Naveen Wadhwa, Vice-President, Taxmann, and CA Rahul Singh, Senior Manager, Taxmann. Views are personal)
