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Frequently asked questions on Exchange Traded Funds (ETFs): the complete guide

This article compiles an exhaustive list of FAQs on the concept of Exchange Traded Funds (ETFs).

Frequently asked questions on Exchange Traded Funds (ETFs): the complete guide


Posted on 02 Feb 2024
Author: Sayan Sircar
14 mins read
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This article compiles an exhaustive list of FAQs on the concept of Exchange Traded Funds (ETFs).

Frequently asked questions on Exchange Traded Funds (ETFs): the complete guide

FAQ: Exchange Traded Fund (37 items)

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What is an Exchange Traded Fund (ETF)?

An Exchange Traded Fund (ETF) is a type of mutual fund which has shares that trade intra day on stock exchanges. It holds assets like stocks, bonds, or commodities. You can invest in an ETF by either buying or selling them like any share. If you are investing a large amount at one go, the AMC will offer to sell you a block to ETF shares directly.


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Are ETFs active or passive?

ETFs are generally passive investments tracking general indices like the Nifty 50, SENSEX or commodities like Gold. Nowadays, ETFs tracking other indices like Midcap, Smallcap etc. or factor indices like Quality, Low Volatility and Momentum are also available.


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Are ETFs closed ended funds?

An ETF is somewhere in-between open and closed ended funds. Like a close ended mutual fund, ETFs are traded in a stock exchange without changing the number of shares. However, like an open ended fund where anyone can buy units at end-of-day NAV, in-kind creation and redemption of units is possible.


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Are there different types of ETFs?

Yes, there are equity ETFs, bond ETFs, commodity ETFs, and more. Some focus on specific sectors or follow smart-beta strategies like low volatility, momentum or quality.


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Are there tax implications with ETFs?

ETFs are taxed in the same way as mutual funds. Equity ETFs are taxed at 15% for short-term (less than 1 year) and 10% (over 1 lakh of gains) in the long-term. Debt and commodity ETFs are taxed at slab rates.

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Are we able to transfer ETFs to another demat account like how we do for equity?

ETFs can be transferred from one demat account to another just like any share. The process is either online (CDSL > CDSL) or offline via Delivery Instruction Slip.


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Can ETFs be managed without demat account?

ETFs are generally bought or sold via a trading account via stock exchange and kept in a demat account. Even if you use the creation unit route by approaching the AMC directly to buy/sell ETFs (typically in crores), then also the ETF shares come to the demat account. Therefore, a demat account is mandatory for ETFs.


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Can I use ETFs for long-term investing?

Yes, ETFs can be suitable for long-term investors. They provide a cost-effective way to build a diversified portfolio.


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Do all ETFs have a liquidity issue?

Most ETFs in India might have a liquidty issue in case the daily volumes are not high. If you are investing a large amount at a time, or exiting a position, you will be adversely impacted if the volumes are not high.


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Do ETFs give dividend?

If the shares inside the ETF give dividend, they get added to the cash balance of the ETF. After netting that cash with the inflow/outflow of cash for creation of units, the amount is invested into the same stocks of the portfolio in the same proportion. Some ETFs, typically SBI Nifty 50 sometimes give out a dividend from it’s cash holding. This dividend is paid out to the shareholders, is taxable at slab and then the NAV of the ETF falls by the same amount.


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Do investors pay tax when the ETF buys or sells shares?

ETFS, just like mutual funds, are tax pass-through for investors. When the fund manager sells shares inside the ETF, the investors do not pay tax. Investors pay capital gains tax only when they sell the ETF shares.


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Do you need a demat account to purchase ETF?

An ETF trades in the stock market like any share. So you need a demat account to store the ETF and a brokerage (or trading) account to buy and sell ETFs. If you are investing (or redeeming) a large amount of money, typically in crores, then you can directly approach the AMC to buy/sell a block of ETF shares.


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How are ETF prices determined?

ETF prices are determined by market demand and supply. Generally, they closely track the net asset value (NAV) of their underlying assets. The intraday NAV (iNAV) is available on the AMC website and helps you to check how closely the ETF is trading close to NAV.


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How do ETFs work?

ETFs represent a basket of assets, mirroring an index or a specific sector. They trade on stock exchanges, allowing investors to buy or sell them throughout the trading day at market prices.


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How do I buy and sell ETFs?

Investors can buy and sell ETF shares through brokerage accounts, similar to individual stocks. Brokerage costs and STT will apply depending on the type of trade you are executing.


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How does arbitrage work in the case of an ETF?

Authorised participants and market makes ensure that ETFs always trade close to the NAV by taking advantage of and thereby removing arbitrage opportunities. If the basket of underlying ETF is trading as a discount to NAV, they will buy the basket, deliver the shares to the ETF issuers and sell the received ETF units in the market at the current higher price. They do the reverse (buy ETF units, deliver to AMC and sell the underlying stocks) if the ETF trades at a premium to NAV.


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How easy is it to sell a large position in an ETF?

Think liquidity is a major problem in most ETFs in India and investors might find it difficult to sell (or buy) a large position without affecting the market price which makes the trade more expensive for them. Instead, if the size of the position is large enough, typically in crores, then the investor can approach the AMC for an in-kind redemption of the whole amount.


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How many shares does an ETF have?

ETFs have a fixed numbers of shares at any time since people buy and sell ETF shares to each other in the stock exchange. New ETF shares are created or destroyed when an investor approaches the AMC directly, typicatlly with crores, to create a large block of ETF shares called creation unit in retunr for their investment. Only then, the number of ETF shares outstanding will change.


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How much do ETFs cost?

As passive funds, ETFs have a total expense ratio (TER) much lower than mutual funds that track the same benchmark. However, choosing an ETF solely based on TER is a trap. The important considerations are daily volume, which determing how long it takes to build/exit a position at prices close to NAV, and how the tracking error (and differnce) is relative to the benchmark.


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How to buy an ETF?

ETFs are bought and sold via trading account by noting the trading price vs the iNAV of the fund. Once purchased, the ETF shares are stored in a demat account.


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If an underlying stock declares dividend then is it paid immediately to the investor by the ETF?

When an underlying stock declares a dividend, it becomes a part of the cash balance of the ETF and then reinvested in the same stocks of the ETF in the same proportion. It is not directly paid out to investors. In India, most ETFs are of the growth type, unlike US ETFs, and do not pay dividends. All the stock dividends are reinvested.


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Should investors choose ETFs instead of Mutual funds for the long-term?

Although ETFs have a lower expense ratio compared to index funds tracking the same index, liquidity considerations that affect trading price, tracking error and tracking difference as well as AuM affect what the long-term return of the ETF will be compared to the equivalent mutual fund. At some point, it is simply easier to purchase a mutual fund with less uncertainty on the returns vs the benchmark.


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Should investors choose ETFs instead of Mutual funds for the short-term?

Unlike the long-term case, intraday trading is a good use case of ETFs. Since mutual funds can only be purchased at end-of-day NAV, an ETF allows you to benefit from rapid intraday prices fluctuations.


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What are price and NAV of an ETF?

Net Asset Value (NAV) of an ETF is calculated in the same way as that of any mutual fund: total assets (minus expenses called TER) divided by the number of shares of the ETF. When the total assets are valued after market close, then we get the NAV. During the trading hours, ETF trades at a price close to the intraday NAV (iNAV) based on demand-supply factors.


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What are the major problems with an ETF?

The major problems with ETFs in India, and to an extent in other markets as well, relate to the price-NAV variation and liquidity. These two issues are related. Most ETFs trade with extremely small number of units every day and have large gaps in their buy and sell prices (called wide bid-ask spreads). Such ETFs also trade at a major discount to their NAV which means that the investor generally makes quite different return compared to the benchmark.


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What are the risks associated with ETFs?

While generally considered low-risk, ETFs still carry market risks. Prices can be influenced by factors affecting the underlying assets.


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What happens to dividends in ETFs?

Dividends get added to the cash-balance of the fund. Post adjustments for withdrawals, the cash is reinvestd in the underlying assets of the ETF in the same proportion as the rest of the fund.


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What is in-kind creation and redemption of ETFs?

AMCs offer a facility to directly sell units to an investor who is investing a large amount with them typically in crores. This is called in-kind creation where the AMC takes the investor’s money and directly allots ETF shares called creation unit. The reverse process is called in-kind redemptions. Typically for a Nifty 50 ETF, with price around ₹250/share, the minimum number of shares is 40,000 which means that a minimum of ₹1 crore has to be invested or redeemed at time.


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What is iNAV?

The intraday NAV (iNAV) is available on the AMC website and helps you to check how closely the ETF is trading close to NAV. Whenever you are buying or selling an ETF, always check that you are doing the trade as close as possible to the iNAV. The iNAV is calculated from the near-realtime prices of the underlying stocks of the ETF and are continuously published during trading hours.


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What is market making in an ETF?

Market makers provide both buy and sell quotes on the stock exchange for newly launched or even older ETFs to ensure that investors can buy and sell close to the iNAV. Therefore market makers provide liquidity in the secondary market and in most cases the AMCs, though their own brokerage house, can be the market maker. They match the buyers and the sellers in the stock exchange.


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What is the best price for buying an ETF?

An ETF can never be purchased at NAV unless you are approaching the AMC directly with a very large chunk of money for in-kind creation. If you are trading ETFs, you will have to pay a large spread (lower price for selling vs buying) unless the ETF has a high volume and trades close to iNAV. The price that you pay to trade the ETF is therefore unpredictable and can be very different compared to the end-of-day NAV.


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What is the liquidity issue seen with ETFs?

Most ETFs trade at very low volumes in the stock exchange due to lack of interest from investors. Such ETFs have large gaps in their buy and sell prices (called wide bid-ask spreads). Such ETFs also trade at a major discount to their NAV which means that the investor generally makes quite different return compared to the benchmark. To avoid ETFs that do this, you need to check the consistency of the ETFs performance vs the benchmark.


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What is VWAP of an ETF?

Volume Weighted Average Price (VWAP) of an ETF is avaiable on the NSE website and gives a reasonable approximation of how close the ETF trades close to its NAV. Investors should choose ETFs that trade close to their iNAV for any trade and generally have a VWAP close to the NAV.


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What makes ETFs different from mutual funds?

Unlike mutual funds, ETFs trade like stocks. They provide intra-day liquidity, allowing investors to buy and sell at any time during market hours.


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What should investors do when the ETF splits its shares?

Many ETFs have, in the last few years, have split their units by 10 or 100 times to reduce the per unit cost. A good example is gold ETFs which used to be 1 share equal to 1 gram of gold. Most gold ETFs shares today have been split into 100 shares so each share of the ETF is equivalent to 1/100th of a gram. Investors will automatically get the new number of shares of the ETF post split and the market price also adjusts.


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Who are authorised participants in the case of an ETF?

Authorised participants (APs) are AMCs or the ETF-issuing financial institution that continuously create and redeem ETF units in the primary market to ensure that the price of the ETF stays as close as possible to it’s NAV.


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Why are ETFs popular?

ETFs offer diversification, low expense ratios, and transparency. Investors can gain exposure to a broad market or a specific sector without buying individual assets. In India, there are 180+ ETFs today.


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This post titled Frequently asked questions on Exchange Traded Funds (ETFs): the complete guide first appeared on 02 Feb 2024 at https://arthgyaan.com


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