Investment is a strategic financial decision that individuals make to allocate their funds into various instruments and avenues, each serving distinctive purposes based on their financial objectives. Some perceive investment solely as a strategy to generate wealth and effectively manage their finances, whereas others approach it as a method to establish a retirement nest egg. These motivations may differ, but the ultimate goal remains consistent: to expand one's financial resources by leveraging their income and savings.
ETFs or exchange-traded funds and mutual funds are popular form of investments that offer exposure to a wide variety of asset classes and niche markets. Let's know about the differences before you opt to invest.
ETFs vs Mutual Funds
A Mutual Fund can be referred to as a collective investment scheme that pools money from a group of investors sharing similar financial objectives and risk appetites. This pooled capital is then strategically invested across a diversified range of securities and assets by a designated fund manager. The role of the fund manager is crucial, as they conduct thorough assessments to determine the most suitable securities to invest in based on the fund's investment strategy.
Investors have the opportunity to purchase units of the Mutual Fund, which subsequently yield returns based on the performance of the underlying assets. Fund houses and managers, equipped with specialized market knowledge and expertise in various securities, aim to construct a well-diversified portfolio with the primary goal of achieving maximum returns for the investors involved.
Mutual Funds can generally be classified into three primary categories based on asset allocation strategies: equity funds, debt funds, and hybrid funds. Equity funds predominantly allocate a significant portion of the fund towards investments in shares of diverse companies, aiming to benefit from the potential growth in stock prices. On the other hand, debt funds primarily focus on investing in a range of debt instruments such as government bonds and securities to generate income through interest payments and capital appreciation over time.
Exchange-traded funds (ETFs) are passive investment funds that trade on exchanges. They are popular among investors due to their flexibility, low costs, and tax efficiency. ETFs typically track a specific index, offering investors a bundle of assets that can be bought and sold during market hours. By investing in ETFs, investors can reduce risk and exposure in their portfolios while diversifying their investments.
Investment and trading
The primary difference between Exchange-Traded Funds (ETFs) and Mutual Funds lies in their trading characteristics and management styles. ETFs are designed to be actively bought and sold on exchanges, similar to individual stocks, offering investors the flexibility to trade them throughout the trading day. Conversely, Mutual Funds can only be purchased from a fund house but may be listed on exchanges, providing limited trading flexibility.
Exchange-traded funds (ETFs) provide retail investors with a highly appealing feature known as liquidity. ETFs offer the advantage of being tradable at any point during trading hours, with prices determined by the market.
Similar to stocks, ETFs permit investors to purchase shares as well as engage in short selling. Furthermore, investors have the option to trade call and put options on ETFs. In contrast, mutual funds execute buy or sell orders at the close of the trading day based on their end-of-day Net Asset Value (NAV).
Unlike ETFs, taking short positions in mutual funds is not possible, and there is no availability of call and put options. Notably, ETFs typically do not impose a minimum initial investment requirement, unlike mutual funds.
Moreover, ETFs typically do not have minimum lock-in periods, allowing investors to buy or sell them at their discretion. On the contrary, Mutual Fund units often come with minimum lock-in periods, and selling them before this duration can result in penalty charges.
Furthermore, Mutual Funds are actively managed by fund managers or professionals who make strategic investment decisions, aiming to outperform the market. In contrast, ETFs are passive investment vehicles that aim to replicate the performance of a specific index or benchmark, offering cost-effective investment options with lower management fees.
Taxation of ETFs
Tax structure on dividend income: The tax imposed on dividend income is known as the dividend distribution tax (DDT). Previously, before the financial year 2020-2021, a DDT rate of 15% was applicable to all dividends distributed to investors. However, with effect from the financial year 2020-2021, the concept of DDT was eliminated, and dividend income is now included in the investor's annual income.
The tax rate for dividend income is now aligned with the individual investor's applicable income tax slab rate.
Tax structure on capital gains: Capital gains can be classified as long-term or short-term, and the tax treatment varies based on this distinction, as well as the type of Exchange-Traded Fund (ETF) in consideration.
For Equity ETFs: Equity ETFs are funds primarily focused on investments in equities or related financial instruments. The tax structure for capital gains on these ETFs is analogous to the tax treatment applied to capital gains from individual stock investments.
Capital gains are generally categorized as short-term capital gains if the income is derived from the sale of assets that were held for less than a year. On the other hand, capital gains are classified as long-term capital gains if the holding period exceeds one year.
Under section 112A of the Income Tax Act, a tax deduction of up to INR 1 lakh is applicable for all long-term capital gains. Any amount above this threshold will be subject to a 10% tax rate without the benefit of indexation.
According to section 111A of the Income Tax Act, short-term capital gains are taxed at a rate of 15%, along with any applicable surcharge and cess.
Taxation of Gold, debt ETFs
The tax structure governing gold, debt, and other ETFs is quite similar. However, there are distinct definitions for long-term and short-term capital gains in this context.
Short-term capital gains are realized if the proceeds stem from the sale of assets held for a period less than 3 years. Conversely, long-term capital gains are recognized when the holding duration exceeds 3 years.
In the case of long-term capital gains derived from gold, debt, or international ETFs, the tax rate stands at 20%, accompanied by indexation benefits.
On the other hand, short-term capital gains are treated differently, as the profits are added to the investor's annual income and subjected to tax based on the prevailing income tax slab rates.