Exchange-traded funds (ETFs) are popular investment instruments that offer investors a diversified portfolio at a low cost. Let us understand different types of ETFs and their benefits.
What is an ETF?
An ETF is a pooled investment security similar to a mutual fund (MF). Usually, ETFs track a particular commodity, sector, index, or other assets. However, unlike MFs, ETFs can be sold or purchased on a stock exchange like regular stock. Moreover, the best ETF funds can be structured to track anything like a basket of stocks.
Types of ETFs
Here are some of the prominent types of ETFs.
Passive and active ETFs
ETFs can either be actively or passively managed. Actively managed ETFs usually don’t target an index of securities. Instead, they have portfolio managers who decide which securities to include in the portfolio. Active ETFs tend to be more expensive compared to their passive counterpart. The objective of passive ETFs, on the other hand, is to replicate the performance of a broader index. This could be a diversified index like the BSE Sensex or a more specifically targeted trend or sector.
The objective of bond ETFs is to provide regular income to investors, whose distribution depends on how the underlying bonds perform. The investments could include state and local bonds, also known as municipal bonds, corporate bonds, and government bonds. Also, bond ETFs don’t have a maturity date, unlike their underlying instruments. Besides, they usually trade at a discount or premium to the actual bond price.
Stock or equity ETFs invest in a basket of stocks that track a sector or an industry. The objective is to include securities that have the potential for growth. However, stock ETFs have lower fees and don’t involve actually owning the securities, unlike MFs.
Sector or industry ETFs focus on a specific industry or sector. For instance, energy sector ETFs will include companies operating in that sector. The idea is to gain exposure to that industry’s upsides by tracking the performance of businesses. Industry ETFs are also used during economic cycles to rotate in and out of sectors.
Commodity ETFs invest in commodities, including gold or crude oil. They provide many advantages and help a portfolio diversify. It’s easier for investors to hedge downturns. For instance, commodity ETFs can make for a good cushion during a stock market slump. Besides, holding shares in commodity ETFs is cheaper than physically holding the commodity. That’s because holding commodity ETF shares doesn’t involve storage and insurance costs.
Currency ETFs are pooled investment vehicles that track the performance of currency pairs that consist of foreign and domestic currencies. They serve multiple purposes. Currency ETFs bet on the prices of currencies based on a country’s economic and political developments. Besides, importers and exporters use them as a hedge against volatility in forex markets and to diversify a portfolio.
Here’s a useful CoinSwitch article on how to use index funds for diversification.
Inverse ETFs use derivatives to short stocks, that is, selling stocks expecting them to decrease in value and then buying them back at a lower price. When that happens, inverse ETFs increase by a proportionate amount. However, many inverse ETFs are not true ETFs but rather Exchange-Traded Notes (ETNs), which are issuer-backed bonds but trade like stocks. So, cross-check with your broker to see if ETNs are a good fit for your portfolio.
Leveraged ETFs employ leverage to boost the returns of the underlying investments. For example, if the Nifty 50 rises 1%, a 3x leveraged Nifty 50 ETF will return 3%, making the same loss if the index falls. These products use derivatives such as futures or options contracts to leverage their returns.
Benefits of exchange traded funds (ETF)
Talking about ETF advantages, they are easy to trade. They’re transparent as most ETFs publish their holdings every day. Moreover, ETFs are also more tax-efficient as they usually generate lower capital gain distribution levels than actively managed MFs. Finally, you can have a variety of trading transactions with ETFs since they’re traded like stocks.
Tax on income from exchange-traded funds (ETF)
- Taxes on dividend income: From the financial year 2020-2021, there is no dividend distribution tax. Instead, the dividend income you earn from ETF/stocks gets added to one’s annual income and taxed according to your income tax slab.
- Taxes on capital gains: Taxes on capital gains depend on whether they’re short/long term and the kind of ETFs. If the income is from the sale of stocks you’ve held for more than a year, they are long-term capital gains. Income from investments held for less than one year comes under short-term capital gains.
Many investors use ETFs to gain exposure to several industries and sectors, and if invested diligently, they can ensure excellent returns.
Which ETF has the highest return?
As we have discussed, ETFs are popular investment vehicles with many benefits. While selecting an ETF depends on your individual situation, a general rule of thumb is to avoid sector-specific bets. Do your research, analyze long-term performance (at least five years), evaluate the credentials of the fund house, and choose an ETF.
What is the benefit of an ETF?
ETFs offer investors a diversified portfolio at a low cost. They provide more flexibility as they trade like stocks.
Do ETFs give good returns?
If you make your selection carefully, ETFs can give good, inflation-adjusted returns over time.
Which type of ETF is the best?
ETFs that track benchmark indices like the BSE Sensex or Nifty are generally recommended for first-time investors.