Exchange-Traded Funds (ETFs)
Exchange-traded funds (ETFs) are mutual fund schemes that track an index or asset, such as the Nifty 50, gold or bonds, and whose units are bought and sold on a stock exchange like shares.
What Is an Exchange-Traded Fund (ETF)?
An exchange-traded fund (ETF) is a mutual fund scheme whose units are listed and traded on a stock exchange, just like shares. Most ETFs are passive: they track an index (such as the Nifty 50 or Sensex), a commodity (such as gold or silver) or a basket of bonds. SEBI's categorisation rules treat index funds and ETFs together, requiring at least 95% of total assets to be invested in the securities of the index being tracked.
Unlike regular mutual funds, which you buy from the fund house at the end-of-day NAV, you buy and sell ETF units through a stockbroker, during market hours, at the prevailing market price. You need a demat and trading account.
How Does an ETF Work?
- Creation: The AMC creates ETF units in large blocks ("creation units") in exchange for cash or the underlying basket, mainly with market makers and large investors.
- Listing: Units are listed on the stock exchange.
- Trading: Retail investors buy and sell units from each other on the exchange. Prices change through the day.
- Market makers: The AMC appoints market makers who offer buy and sell quotes to improve liquidity and keep the price close to the underlying value.
- iNAV: An indicative NAV (iNAV) is published during the trading day so investors can compare the market price with the value of the underlying holdings.
- Direct dealing with the AMC: Generally limited to market makers and investors transacting above a size threshold set by SEBI. Scheme documents describe when smaller investors may redeem directly, for example if the ETF has no quotes on the exchange for a specified period.
Practical Example
Illustrative: Arjun buys 100 units of a Nifty 50 ETF.
- iNAV at the time = ₹245.10; market price = ₹245.30
- Premium = (₹245.30 − ₹245.10) ÷ ₹245.10 × 100 ≈ 0.08%
- Cost = 100 × ₹245.30 = ₹24,530, plus brokerage (assume ₹20) = ₹24,550
A year later, he sells 100 units at ₹262.40:
- Sale value = 100 × ₹262.40 = ₹26,240, less brokerage of ₹20 = ₹26,220
- Net gain = ₹26,220 − ₹24,550 = ₹1,670
Assumptions: brokerage of ₹20 per order; statutory charges ignored for simplicity. If he had bought when the ETF was trading at a larger premium, his return would have been lower. Figures are hypothetical.
Why Is It Important?
- Low ongoing costs: ETFs often have very low expense ratios.
- Intraday flexibility: You can trade at real-time prices during market hours.
- Liquidity matters: Thinly traded ETFs can have wide bid-ask spreads or trade away from iNAV, increasing your effective cost.
- Access to many assets: Equity indices, gold, silver, bonds and international indices are available through ETFs.
Key Features
| Feature | ETF |
|---|---|
| Where traded | Stock exchange, during market hours |
| Price | Market price, which may differ from NAV/iNAV |
| Account needed | Demat and trading account |
| Costs | Expense ratio + brokerage + bid-ask spread + statutory charges |
| SIP | Possible through some brokers, not through the AMC in the usual way |
| SEBI minimum | 95% in securities of the tracked index |
Tax treatment
Taxation depends on what the fund tracks. Equity index funds and equity ETFs that keep at least 65% in domestic listed equity are taxed as equity-oriented funds: as per rules applicable from 23 July 2024, 20% on gains for units held up to 12 months, and 12.5% on gains above ₹1.25 lakh a year for units held longer, plus surcharge and cess. Debt index funds and debt ETFs investing more than 65% in debt and money market instruments are specified mutual funds from FY 2025-26, so gains on units bought from 1 April 2023 are taxed at slab rates. Gold, silver and international products follow other rules. Check the provisions in force for your year or consult a tax adviser.
Benefits and Limitations
| Benefits | Limitations |
|---|---|
| Low expense ratios | Need demat and trading account |
| Real-time pricing and trading | Brokerage, spreads and other charges |
| Transparent holdings | Low trading volumes in some ETFs |
| Access to commodities and bonds | Price can trade at a premium or discount to NAV |
| No exit load on exchange sales | Tempting to trade frequently |
Comparison With Related Concepts
| Concept | Meaning | Key difference | Practical implication |
|---|---|---|---|
| ETF | Fund traded on an exchange | Intraday market price | Check liquidity and premium to iNAV |
| Index Fund | Mutual fund tracking an index, bought from AMC | End-of-day NAV, no demat | Easier for automatic SIPs |
| Gold ETF | ETF tracking domestic gold prices | Commodity, not equity | Different tax and risk profile |
| Direct shares | Buying individual stocks | Concentrated in chosen companies | No expense ratio, but more research needed |
For a detailed comparison, see Index Funds vs ETFs.
How Does It Apply to Mutual Fund Investors?
- Check liquidity: Look at average daily traded volume and the bid-ask spread before buying.
- Compare price with iNAV: Avoid buying at a large premium or selling at a large discount.
- Use limit orders: These help control the price you pay.
- Consider index funds if you prefer simplicity: For automatic SIPs without a demat account, an index fund on the same index may be easier.
- Review tracking error: As with index funds, closer tracking is better.
Common Mistakes and Misconceptions
- "The ETF price always equals NAV." Market prices can differ from NAV, especially in less liquid ETFs or volatile markets.
- "ETFs have no costs beyond the expense ratio." Brokerage, spreads and statutory charges add up, particularly with frequent trading.
- "All ETFs are equity funds." Gold, silver, bond and international ETFs carry different risks and tax treatment.
- "Intraday trading in ETFs improves returns." Frequent trading usually adds costs and timing risk for long-term investors.
Important Terms to Know
- Index Funds: Mutual funds that track an index, bought from the AMC.
- Index Funds vs ETFs: Comparing the two passive routes.
- Gold ETFs: ETFs that track the price of gold.
- Tracking Error: Deviation of returns from the index.
- Liquidity: Ease of buying or selling without affecting the price.
- Net Asset Value (NAV): The per-unit value of the underlying portfolio.
Key Takeaways
- ETFs are mutual fund schemes whose units trade on stock exchanges like shares.
- You need a demat and trading account, and you pay market prices plus trading costs.
- Check liquidity, bid-ask spreads and the gap between market price and iNAV.
- Tax depends on the underlying asset: equity, debt, gold or international.
- Index funds offer a simpler alternative for SIP investors.
Related Glossary Terms
References
- SEBI circular: Categorization and Rationalization of Mutual Fund Schemes (26 February 2026)
- AMFI Knowledge Centre: Categorization of Mutual Fund Schemes
- Income Tax Department: Tax on long-term capital gains
- Income Tax Department: Section 76, Income-tax Act, 2025 (specified mutual funds)
Educational Disclaimer
This content is for educational and informational purposes only. It is not personalised investment, tax or legal advice, and it does not recommend any specific scheme. Mutual fund investments are subject to market risks; read all scheme-related documents carefully. Rules and tax provisions mentioned here reflect our understanding at the time of writing and can change. Before investing, consider your financial goals, risk profile and investment horizon, and consult a qualified professional where needed.
Compare passive options further in Index Funds vs ETFs and other related terms in the FynnChintan Financial Glossary. Beyond Numbers. Into Opportunities.
Frequently Asked Questions
Why does an ETF sometimes trade at a premium or discount?
Market prices reflect supply and demand on the exchange. If buying or selling interest is strong, or market makers are not active enough, the price can move away from the underlying value. Larger, more liquid ETFs usually trade closer to iNAV.
Do I need a demat account to invest in ETFs?
Yes. ETF units are listed on stock exchanges, so you need a demat account to hold them and a trading account to buy and sell them through a broker. If you prefer not to open one, an index fund tracking the same index can be an alternative.
What is iNAV in an ETF?
iNAV, or indicative NAV, is an estimate of the ETF's per-unit value published during market hours. Comparing the market price with iNAV helps you see whether you are paying a premium or selling at a discount to the underlying holdings.
Can I do a SIP in an ETF?
Some brokers offer periodic purchase plans for ETFs, but it is not a standard AMC SIP. Each purchase is a market transaction with brokerage. Investors who want simple automatic SIPs often use index funds instead.
Are ETFs better than index funds?
Neither is universally better. ETFs may have lower expense ratios and intraday trading, but need a demat account and carry trading costs and liquidity considerations. Index funds are simpler for SIPs. The right choice depends on how you invest.
This explanation is for general education only and is not investment advice. Mutual fund investments are subject to market risks; read all scheme-related documents carefully.