What are Equity ETFs?- Meaning, How they work?, Benefits, Risks

Investing in the stock market can be intimidating, especially for those who are new to the world of finance. However, with the advent of exchange-traded funds (ETFs), investing has become more accessible and straightforward. 

While there are various other types of ETFs, such as Thematic ETFs or Commodity ETFs, our primary focus in this chapter will be on Equity ETFs. By the end of this article, you will have a clear understanding of what equity ETFs are, how they work, and how they can help you build a diversified portfolio to achieve your investment goals.

What is an Equity ETF?

Equity ETFs, also known as stock ETFs, are investment funds that trade on stock exchanges, just like individual company stocks. These funds are designed to track the performance of a specific equity index, such as the S&P 500, Nifty 50, or Nifty IT. Equity ETFs offer investors an opportunity to gain exposure to a diversified portfolio of stocks, without the need to buy each stock individually. They are traded on stock exchanges just like individual stocks, and you can buy or sell them during trading hours.

How do Equity ETFs work?

Equity ETFs employ a passive investment strategy called index replication. They aim to replicate the performance of a particular stock index by holding a basket of securities that closely mirror the index's composition. 

For example, if an ETF tracks the S&P 500, it will aim to own the same stocks in the same proportion as the index. This allows investors to participate in the overall market performance without having to select individual stocks.

Equity ETFs are specific to market capitalisation, theme, or sector. This means you can invest in ETFs that focus on large-cap companies, mid-cap companies, small-cap companies, or specific sectors and themes. Equity ETFs also allow you to invest in industries that are currently performing well, such as pharmaceuticals, IT, energy, banking, or any other industry.

For instance, the Nifty Bank index includes top companies from the banking sector. An Equity ETF that tracks the Nifty Bank index aims to closely replicate it and holds the same companies as the index.

How to Evaluate and Select Equity ETFs?

When selecting an equity ETF, consider the following factors:

1. Expense Ratio: Look for ETFs with low expense ratios to minimise costs.
2. Tracking Error: Check how closely the ETF's performance tracks its underlying index.
3. Liquidity: Ensure that the ETF has sufficient trading volume to facilitate easy buying and selling.
4. AUM (Assets Under Management): Consider the size of the fund, as larger funds tend to have greater liquidity.
5. Fund Structure: Understand whether the ETF is structured as physically replicated (holds the underlying securities) or synthetically replicated (uses derivatives to replicate the index).

Suitability and Benefits of Equity ETFs

Are Equity ETFs a good option for you? Well, Equity ETFs are suitable for long-term investors. As passively managed funds, they are suitable for investors who prefer not to engage in active fund management. Equity ETFs have low expense ratios since they are passive funds. So, if you want low-cost exposure to the equity market and don't want to spend a lot of time managing investments, Equity ETFs may be a good choice.

Equity ETFs and Indexes

Equity ETFs have recently become quite popular, with many of them tracking indexes such as Nifty 50, S&P BSE Sensex, Nifty Bank, etc. DSP Nifty 50 ETF, ICICI Pru Nifty 100 ETF, and Nippon India ETF Nifty BeES are the oldest among the total of 89 equity ETF plans available.

1. Sensex ETFs include the 30 largest stocks listed on the BSE, such as ITC, HUL, SBI, and Bharti Airtel. In India, there are approximately 5 Sensex ETFs available, including HDFC Sensex ETF, ICICI Pru Sensex ETF, and LIC Sensex ETF, which provide diversified exposure to the Indian equity market.
2. Nifty Next 50 Index includes companies ranked 51-100 based on market capitalisation, and there are approximately seven ETFs available that allow investors to track the performance of this index.
3. Nifty 50 ETF consists of the top 50 stocks, including Reliance, HDFC Bank, ICICI Bank, Infosys, and other blue-chip firms. There are around 18 ETFs that provide investors with diversified exposure to the Indian equity market.

Tax on Equity ETFs Investments

When investing in any of these ETFs, it's important to consider the tax implications. Capital gains from equity ETF funds are classified as short-term or long-term based on the holding period. 

• Short-term capital gains are taxable at 15%
• Long-term capital gains are taxable at 10%. However, note that long-term capital gains tax applies only when the gains exceed ₹1,00,000 in a financial year.

Key Takeaways:

• Equity ETFs offer a simple and cost-effective way to gain exposure to a diversified portfolio of stocks.
• Understanding the basics of equity ETFs is crucial for successful investing.
• Evaluate the attributes of different equity ETFs before making investment decisions.
• Follow sound portfolio-building principles to optimise your investment strategy.
• Conduct thorough research and consider your investment objectives, risk tolerance, and time horizon.
• Carefully assess the suitability of ETFs based on your individual financial goals.