Mutual Funds Education

ETFs: Exchange-Traded Funds in India

An Exchange-Traded Fund (ETF) is a basket of securities that tracks an index, commodity, or asset class and trades on a stock exchange like a share throughout the day.

On this page · 18 sections

Introduction

If you have ever wished you could invest in the entire Nifty 50 index with a single click - the same way you would buy a share of a company - Exchange-Traded Funds are built exactly for that purpose. An ETF holds a basket of underlying securities and issues units that trade on the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE) just like any other listed share. You can buy one unit at 9:30 in the morning, watch its price move in real time throughout the session, and sell it at 3:15 in the afternoon if you wish - something you simply cannot do with a traditional mutual fund, which settles at the end-of-day Net Asset Value (NAV).

ETFs arrived in India in January 2002 when Benchmark Mutual Fund launched the first Nifty-tracking ETF on the NSE. Since those early days the Indian ETF market has grown dramatically in both breadth and depth. Today you can find equity ETFs that track broad indices such as the Nifty 50, the Sensex, the Nifty Next 50, and the Nifty Midcap 150; sector-specific ETFs covering banking, information technology, and healthcare; international ETFs that give you exposure to US or global indices; fixed-income ETFs tracking government securities and corporate bond indices; gold ETFs that replicate the domestic price of physical gold; and even silver ETFs. As of recent years, the Employees' Provident Fund Organisation (EPFO) itself has channelled a substantial portion of its equity allocation through ETFs, which is a telling endorsement of the structure's transparency and cost-efficiency.

For retail investors in India, ETFs occupy a particularly interesting sweet spot. They are typically far cheaper to hold than actively managed mutual funds because most ETFs are passively managed - the fund manager simply replicates the index rather than actively picking stocks, which keeps the expense ratio low. They are transparent because the underlying portfolio is disclosed publicly every day. They are flexible because you can trade them at any point during market hours. And they are accessible because many ETFs have market prices of just a few hundred rupees per unit, allowing even small investors to gain diversified market exposure without needing large lump-sum amounts.

That said, ETFs are not a magic solution for every investment need. Like any market-linked product they carry risk - prices fall as well as rise, liquidity can vary between different ETFs, and a narrow tracking difference can quietly erode returns over long horizons. Understanding exactly how ETFs work, what types are available in India, how they differ from index funds, and what costs and risks to watch for is essential before you make them part of your portfolio. This guide covers all of that in detail - from the mechanics of the creation and redemption process to practical considerations around demat accounts, brokerage, and taxation under Indian law.

Quick definition

An Exchange-Traded Fund (ETF) is an open-ended investment fund listed and traded on a stock exchange - such as the NSE or BSE - that typically tracks an underlying index, commodity, or basket of assets. Unlike a conventional mutual fund, an ETF can be bought and sold at real-time market prices throughout the trading session, combining the diversification of a fund with the liquidity and convenience of share trading.

How ETFs Work: The Creation and Redemption Mechanism

To understand why ETFs behave the way they do - and why their market price stays so close to the value of the underlying basket - you need to understand the creation and redemption mechanism. This is the engine that drives the entire ETF structure and distinguishes it fundamentally from a closed-ended fund.

An ETF has two layers of participants. On one side are ordinary retail and institutional investors who buy and sell ETF units on the secondary market - that is, on the NSE or BSE - at the prevailing market price, just as they would trade shares. On the other side are large institutional participants called Authorised Participants (APs), who interact directly with the fund house in what is called the primary market.

When an AP wants to create new ETF units, it assembles the actual underlying securities in the exact proportion specified by the ETF's portfolio (called the creation basket) and deposits them with the fund house or its custodian. In exchange, the fund house issues a large block of ETF units - typically called a Creation Unit - to the AP. The AP can then sell these units on the exchange to ordinary investors. The reverse is also possible: the AP can collect ETF units from the market and return them to the fund house in exchange for the underlying securities. This is the redemption process.

This two-way mechanism is what keeps the ETF's market price tethered to its intraday NAV (also called the Indicative NAV or iNAV). If the ETF trades at a premium - its market price is higher than the value of the underlying basket - an AP can create new units cheaply (by depositing the basket) and sell them on the exchange at the higher market price, pocketing the difference and simultaneously pushing the market price back down. If the ETF trades at a discount, an AP can buy units on the exchange cheaply and redeem them for the underlying basket, which is worth more, again pocketing the difference and pulling the market price back up. This arbitrage activity by APs ensures that premiums and discounts to NAV remain small in well-functioning ETFs.

For retail investors on the NSE or BSE, none of this primary market activity is directly relevant to how they transact - they simply place buy or sell orders through their broker like any share trade. But understanding the mechanism explains why ETF prices remain efficient, why some ETFs with fewer APs or lower trading volumes can occasionally drift from their NAV, and why liquidity in the underlying index matters so much to the overall health of the ETF.

In India, SEBI has issued detailed regulations governing ETFs under the SEBI (Mutual Funds) Regulations, 1996 and subsequent circulars. Fund houses that offer ETFs must comply with these regulations, which include requirements around portfolio replication, disclosure of the iNAV at regular intervals during trading hours, and appointment of market makers to maintain liquidity.

Types of ETFs Available in India

The Indian ETF landscape has diversified considerably over the past two decades. Today, investors can choose from several broad categories, each designed to track a different type of underlying asset.

Equity Index ETFs These are the most popular ETFs in India and they track stock market indices. Broad-market ETFs replicate indices such as the Nifty 50 or the BSE Sensex, giving investors exposure to the fifty or thirty largest listed companies in a single instrument. Beyond these flagship indices, there are ETFs tracking the Nifty Next 50 (the next fifty companies after the Nifty 50), the Nifty 100, the Nifty Midcap 150, the Nifty Smallcap 250, and various strategy indices such as the Nifty 50 Equal Weight or the Nifty 50 Value 20.

Sectoral and Thematic ETFs These ETFs focus on a specific industry or theme. In India you will find ETFs based on the Nifty Bank index (covering banking stocks), the Nifty IT index (information technology companies), Nifty Pharma, Nifty FMCG, Nifty Infrastructure, and others. Thematic ETFs may focus on broader investment themes such as consumption, ESG (Environmental, Social, and Governance), or dividend opportunities. Because these concentrate in a single sector, they carry higher risk than broad-market ETFs.

Gold ETFs Gold ETFs were introduced in India in 2007 and track the domestic price of physical gold. Each unit of a gold ETF typically represents one gram (or a fraction thereof) of gold. The fund holds actual gold in the form of bullion with a custodian. Gold ETFs allow investors to take exposure to gold prices without the hassles of physical storage, making charges, or purity concerns. They trade on the NSE and BSE just like equity ETFs.

Silver ETFs Silver ETFs are a more recent addition, introduced following a SEBI circular in 2021. Like gold ETFs, they hold physical silver and track its domestic price. They give investors a convenient way to invest in silver as a commodity without holding the metal physically.

Debt / Fixed-Income ETFs Debt ETFs in India track fixed-income indices such as the Nifty AAA Bond index, Nifty CPSE Bond index, or government securities indices. The Bharat Bond ETF series, launched in collaboration with SEBI and the government, is a notable example of a target-maturity debt ETF in India. These ETFs invest in bonds and debt instruments and are designed for investors seeking more stable, income-oriented returns. They are generally considered lower risk than equity ETFs, though they carry interest rate risk and credit risk.

International / Global ETFs Some Indian fund houses offer ETFs that invest in overseas markets - for example, ETFs that replicate the performance of the S&P 500, the Nasdaq 100, or other international indices. These ETFs are structured as fund-of-funds (FoF) or as direct ETFs and are listed on Indian exchanges. They allow domestic investors to achieve geographical diversification without opening a foreign brokerage account, though they are subject to RBI's Liberalised Remittance Scheme (LRS) limits and relevant SEBI guidelines.

CPSE and PSU ETFs India has also seen government-sponsored ETFs tracking baskets of Central Public Sector Enterprise (CPSE) stocks, used by the government as a tool for disinvestment. These ETFs invest in listed public sector companies and have sometimes been offered with a small discount to NAV during New Fund Offer (NFO) periods, attracting retail interest.

Each category serves a different investment objective, risk appetite, and portfolio role, and it is important for investors to assess which type aligns with their individual financial goals before investing.

ETFs vs Index Mutual Funds: Understanding the Differences

One of the most common questions Indian investors have is: what is the difference between an ETF and an index mutual fund? Both are passive instruments that track an index, both are regulated by SEBI, and both aim to replicate the returns of the underlying benchmark. But there are several meaningful structural differences that can affect which is more suitable for a given investor.

Trading and Pricing The most fundamental difference is how they are bought and sold. An index mutual fund is purchased and redeemed directly with the fund house (or through a distributor or platform) at the end-of-day NAV. You place an order during the day, but you transact at the NAV computed after the market closes. An ETF, by contrast, trades on the NSE or BSE throughout the day at a live market price that fluctuates with demand and supply. This means ETFs offer intraday liquidity - you can enter and exit at any point during market hours at the prevailing price.

Demat Account Requirement To invest in an ETF you need a demat account and a trading account with a SEBI-registered stockbroker. Index mutual funds do not require a demat account - you can invest directly through the fund house's website, an aggregator platform, or a distributor. For investors who already have a demat account (as anyone trading shares would), this is not an extra burden. But for someone who only wants to invest in passive products and has no other reason to maintain a demat account, the ETF route involves slightly more setup.

Expense Ratios ETFs typically have lower expense ratios than even direct plans of index mutual funds. Because ETFs do not incur costs associated with constant daily purchases and redemptions (that burden falls on the secondary market), and because the fund structure is leaner, the ongoing cost is usually fractionally lower. Over a long investment horizon, even a difference of a few basis points can compound meaningfully on a large corpus.

Tracking Difference and Tracking Error Both ETFs and index funds experience some deviation from the index they track. This is measured as tracking difference (the gap between the fund's total return and the index's total return over a period) and tracking error (the standard deviation of that gap over time). For ETFs, tracking difference is influenced by the expense ratio, dividend reinvestment timing, cash drag, and the bid-ask spread incurred when buying and selling securities in the portfolio. For index funds, cash held for liquidity and redemptions can also cause drift.

Systematic Investment For investors who want to invest a fixed amount every month - akin to a Systematic Investment Plan (SIP) - index mutual funds are considerably more convenient. You can automate a monthly investment in an index fund directly through a platform. With ETFs, you need to manually place a buy order each time, and since ETF prices fluctuate, a fixed rupee amount may not always divide evenly into whole units. Some brokers are now offering SIP-like features for ETFs, but they are generally not as seamless as mutual fund SIPs.

Minimum Investment Index mutual funds can be started with as little as ₹100 or ₹500 in many cases. ETFs can only be bought in whole units, so the minimum investment is whatever the current market price of one unit is. For some ETFs this may be ₹50, for others it may be ₹3,000 or more. This can be a practical consideration for very small ticket sizes.

In summary, ETFs are generally better suited for investors who already have a demat account, want intraday flexibility, and are comfortable with lump-sum investing. Index mutual funds are often more practical for those who want to automate monthly investments or who prefer the simplicity of transacting directly with a fund house.

Costs Involved in ETF Investing

One of the most frequently cited advantages of ETFs is their low cost. But "low cost" does not mean "no cost", and as an investor it is important to understand every layer of cost that can affect your actual returns.

Expense Ratio (Total Expense Ratio or TER) The expense ratio is the annual fee charged by the fund house to manage the ETF, expressed as a percentage of the fund's average daily net assets. It covers fund management fees, trustee fees, custodian charges, registrar and transfer agent fees, and other administrative costs. For passive ETFs in India, the TER is typically very low - often ranging from 0.05% to 0.50% per annum depending on the type of ETF. SEBI has prescribed maximum TER limits for ETFs, and these limits differ from those applicable to actively managed mutual funds. Always check the latest SEBI circular for current limits. The TER is not charged to you directly; it is deducted from the fund's NAV on a daily accrual basis.

Brokerage and Transaction Charges Every time you buy or sell ETF units on the NSE or BSE through your broker, you pay brokerage. The brokerage rate depends on your broker's fee structure - flat-fee discount brokers charge a fixed amount per trade, while traditional brokers may charge a percentage of the transaction value. In addition to brokerage, every equity trade on the exchange attracts Securities Transaction Tax (STT), exchange transaction charges (NSE or BSE turnover charges), SEBI turnover fees, GST on brokerage and transaction charges, and stamp duty. These transaction costs are incurred each time you buy or sell, which means they can add up if you trade frequently. For a long-term buy-and-hold investor who transacts infrequently, the cumulative impact is small; for someone who trades ETFs frequently, these costs can become significant.

Bid-Ask Spread When you look at an ETF's order book on your trading terminal, you will see a best bid price (the highest price someone is willing to pay) and a best ask price (the lowest price someone is willing to sell at). The difference between these two is the bid-ask spread. This is an implicit cost - you buy at the ask and sell at the bid, so the spread is the cost of immediate liquidity. For highly liquid ETFs that track the Nifty 50 with high daily trading volumes, spreads are typically very narrow - sometimes just a few paise. For smaller, less liquid ETFs, spreads can be wider, adding to your effective cost of investing.

Impact Cost For large trades, there is also impact cost - the cost of moving the market price when your order is larger than what the best bid or ask can absorb. This is rarely a concern for retail investors placing small orders, but worth noting for anyone making very large purchases or redemptions.

Tracking Difference As discussed earlier, the tracking difference represents the gap between what you actually earned holding the ETF and what the index itself returned over the same period. Even a small negative tracking difference - where the ETF underperforms the index - is an implicit cost. When comparing ETFs from different fund houses that track the same index, the one with the lower tracking difference (and lower tracking error) is generally the better-managed product, all else being equal.

In total, the true cost of holding an ETF includes the expense ratio, transaction costs (brokerage and levies on entry and exit), the bid-ask spread, and the tracking difference. For long-term passive investors, these costs are still considerably lower than most active funds, but they are not zero.

Taxation of ETFs in India

The tax treatment of ETF gains in India depends on the category of the ETF (equity or non-equity), the holding period, and the applicable provisions of the Income Tax Act as amended by the latest Finance Act. Tax laws are subject to change with each Union Budget, so always refer to the latest Finance Act or consult a qualified tax professional for advice specific to your situation.

Equity ETFs An ETF qualifies as an equity-oriented fund for tax purposes if it invests at least 65% of its assets in domestic equity and equity-related instruments. This includes most broad-market equity ETFs (Nifty 50, Sensex, Nifty Next 50, sectoral equity ETFs, etc.).

For equity ETFs, gains are classified as: - Short-Term Capital Gains (STCG): If you hold units for 12 months or less. The applicable tax rate is as per the current Finance Act - refer to the latest provisions. - Long-Term Capital Gains (LTCG): If you hold units for more than 12 months. LTCG on equity ETFs above the prescribed threshold is taxed at the rate specified in the current Finance Act, without the benefit of indexation.

Equity ETF transactions on the stock exchange are also subject to Securities Transaction Tax (STT) at rates prescribed under the current Finance Act.

Gold and Silver ETFs Gold ETFs and silver ETFs are treated as non-equity funds for tax purposes, since they invest in commodities rather than equity. Their tax treatment has undergone changes in recent Union Budgets. Refer to the latest Finance Act for the current holding period thresholds and applicable STCG and LTCG rates. Indexation benefits, where available, can help reduce the effective tax burden on long-term gains from non-equity ETFs.

Debt ETFs Debt ETFs are also treated as non-equity funds. Their capital gains tax treatment follows the same broad framework as debt mutual funds, which has changed significantly in recent Budgets. Refer to the latest Finance Act for current provisions.

Dividend Income If the underlying ETF distributes dividends (which is rare for Indian ETFs that mostly follow a growth option), such income is taxable in the hands of the investor as income from other sources at the applicable slab rate.

Important Practical Points ETF transactions settle in T+1 on Indian exchanges (in line with the shift to T+1 settlement that SEBI implemented). For taxation purposes, the date of transaction on the exchange is the date of acquisition or sale. When computing holding periods, the date of allotment (for units received through the primary market) or the date of purchase on the exchange (for secondary market purchases) is the starting point.

Always maintain proper records of purchase prices, transaction dates, and brokerage statements for accurate capital gains computation. If you invest through a demat account, your broker's consolidated account statement and the CAS (Consolidated Account Statement) from CDSL or NSDL will carry the relevant records.

How to Invest in ETFs in India: A Step-by-Step Overview

Investing in ETFs in India is very similar to buying shares on the NSE or BSE, and the process is straightforward for anyone who already has a demat and trading account. Here is a detailed overview of the steps involved.

Step 1: Open a Demat and Trading Account To buy or sell ETF units on the secondary market, you need a demat account (to hold the units electronically) and a trading account (to place orders on the exchange). Both are opened with a SEBI-registered stockbroker. If you already trade in equities, you already have what you need. Choose a broker that offers a clean interface, transparent fee structure, and access to both NSE and BSE, where ETFs are listed.

Step 2: Complete KYC Know Your Customer (KYC) compliance is mandatory for all financial investments in India. If you are already KYC-compliant through KRA (KYC Registration Agency) - which you would be if you have a mutual fund account or a trading account - this step is already done. First-time investors need to complete KYC by submitting PAN, Aadhaar, and address proof.

Step 3: Add Funds to Your Trading Account Transfer funds from your bank account to your trading account through NEFT, IMPS, or your broker's linked bank integration. Ensure you have enough balance to cover the cost of the ETF units you wish to buy plus any applicable transaction charges.

Step 4: Research the ETF Before placing an order, review the ETF's Scheme Information Document (SID) and Key Information Memorandum (KIM), which are publicly available on the fund house's website. Check the underlying index, the TER, the AUM of the ETF, the average daily trading volume on the exchange (to assess liquidity), and the tracking difference relative to the index over the past year or more.

Step 5: Place a Buy Order Log into your trading platform, search for the ETF by its ticker symbol (NSE or BSE symbol), and place a buy order. You can place a market order (transact at the best available price immediately) or a limit order (specify the maximum price you are willing to pay). For illiquid ETFs with wide spreads, a limit order is generally more prudent. Enter the number of units you wish to buy and confirm the order.

Step 6: Monitor Your Holdings Once the order is executed, the units will be credited to your demat account after settlement (T+1 for equity ETFs on Indian exchanges). You can track the performance of your ETF holdings through your broker's platform or the exchanges' websites. Compare the ETF's NAV (available on the AMC's website and AMFI's website) against the market price to check whether it is trading at a premium or discount.

Step 7: Sell When Appropriate When you decide to exit, simply place a sell order on the exchange through your trading account, the same way you would sell shares. Ensure the market is open (9:15 AM to 3:30 PM IST on trading days). The proceeds will be credited to your trading account and then to your bank account after settlement.

NFO Route (Optional) Some investors prefer to participate in the New Fund Offer (NFO) of a newly launched ETF, subscribing directly through the fund house or a platform during the NFO window. Units are allotted at the NFO price and then listed on the exchange for secondary trading after listing. The NFO route is less common for ETFs compared to mutual funds, and most investors simply buy from the secondary market after listing.

ETFs and Portfolio Construction: Strategic Uses for Indian Investors

ETFs are versatile instruments that can play multiple roles in an investor's portfolio. Understanding those roles can help you use ETFs more intentionally rather than simply buying one because it seems popular.

Core Holding for Long-Term Wealth Creation The most common strategic use of equity ETFs - particularly broad-market ones tracking the Nifty 50, Sensex, or the Nifty 100 - is as the core of a long-term equity portfolio. Research consistently shows that a significant proportion of actively managed equity funds fail to outperform their benchmark indices consistently over long periods, especially after accounting for fees. An investor who uses a low-cost Nifty 50 ETF as the core of their equity allocation can capture broad market returns at minimal cost. Over a horizon of ten, fifteen, or twenty years, the compounding benefit of lower costs can be meaningful.

Tactical Allocation to Specific Themes or Sectors Investors with a view on a particular sector - banking, technology, pharmaceuticals, infrastructure - can use sector ETFs to express that view without the idiosyncratic risk of picking individual stocks. If you believe the banking sector is well-positioned for a multi-year growth phase, a banking index ETF gives you diversified exposure to the sector rather than betting on a single bank. This is the "satellite" strategy - using core broad-market ETFs for stability and adding smaller allocations to sector ETFs for tilts that reflect your views.

Diversification Across Asset Classes By combining equity ETFs with gold ETFs and debt ETFs, an investor can build a multi-asset portfolio using exchange-traded instruments alone. A simple three-ETF portfolio - one broad equity ETF, one gold ETF, and one debt ETF - can offer diversification across asset classes in a cost-efficient, transparent manner. When equity markets are stressed, gold often acts as a portfolio stabiliser. Debt ETFs can provide steady, lower-volatility returns and reduce overall portfolio risk.

International Diversification India-listed international ETFs allow domestic investors to add geographical diversification to their portfolio. Exposure to developed markets - particularly the US, which has a deep, highly liquid equity market - can reduce the concentration risk of having all investments tied to the Indian economy and Indian corporate earnings.

Parking Liquid Funds Temporarily Liquid or money-market ETFs (where available) can be used to park funds temporarily between investments. They offer slightly better potential returns than a savings account while still being quickly accessible through the exchange.

Using ETFs as Building Blocks for a Passive Strategy For investors who follow a purely passive strategy and are not interested in fund selection or manager evaluation, ETFs allow them to build a complete, index-replicating portfolio at very low cost. This is consistent with the broader global trend toward passive investing, which has grown exponentially worldwide.

Risk Management and Rebalancing ETFs make portfolio rebalancing straightforward. Because they are exchange-listed and intraday-tradeable, you can quickly reduce or increase exposure to a particular asset class when your target allocation drifts due to market movements. This is more flexible than waiting for end-of-day NAV on a mutual fund.

Of course, portfolio construction is deeply personal and should reflect your financial goals, time horizon, risk tolerance, and liquidity needs. ETFs are a tool - a very powerful and cost-effective one - but they work best when used as part of a thoughtfully constructed overall financial plan.

The Role of Market Makers and Liquidity in Indian ETFs

One dimension of the Indian ETF market that is particularly important for investors to understand is the role of market makers and why liquidity varies so dramatically between different ETFs.

What Market Makers Do A market maker is a participant - typically a broker-dealer or a specialised firm - that continuously provides two-sided quotes (both bid and ask) for an ETF on the exchange. By doing so, they ensure that an ordinary investor can always find a counterparty to trade with, even if there is no other retail investor on the opposite side at that moment. Without market makers, an investor wanting to sell units might find no buyers, resulting in a failed trade or a deeply discounted price.

In India, SEBI regulations require ETF fund houses to appoint market makers for their schemes. Market makers are also Authorised Participants and can create or redeem units in the primary market to manage their inventory. When an ETF has active, well-capitalised market makers, its bid-ask spreads are narrow and you can execute trades close to the iNAV. When market makers are thin or passive, spreads widen.

Why Indian ETF Liquidity is Uneven The reality of the Indian ETF market is that liquidity is concentrated. A handful of very large ETFs - particularly those tracking the Nifty 50 and Sensex, as well as gold ETFs - command the bulk of daily trading volume. Many smaller ETFs, including several sector ETFs and some debt ETFs, have very low average daily volumes on the secondary market. This means retail investors in these ETFs may find wide spreads and difficulty executing large orders without moving the price.

A useful rule of thumb: always check the average daily volume of an ETF on the NSE or BSE before investing. You can find this on the exchanges' official websites or on the AMFI website. An ETF with less than a few crores of daily trading volume warrants careful consideration of liquidity risk.

Comparing Trading Volume with AUM An ETF's total Assets Under Management (AUM) and its daily trading volume on the exchange are two different things. A large AUM does not automatically mean high trading volume - it may simply mean that large institutional investors (such as EPFO or insurance companies) hold a large proportion of the units without trading them. The retail investor is primarily exposed to the secondary market trading volume, not the total AUM, when it comes to execution quality.

Using Limit Orders for Illiquid ETFs For ETFs with low secondary market volume, it is always advisable to use limit orders rather than market orders. A market order for an illiquid ETF can end up being executed at a price far from the iNAV, since there may be very few orders in the book. A limit order lets you specify the maximum price you will accept, protecting you from inadvertent overpaying or underselling.

The Improving Ecosystem The good news is that SEBI and the exchanges have been actively working to improve ETF liquidity in India. Regulatory changes requiring more active market making, improved disclosure norms, and growing investor awareness have gradually improved the ecosystem. As institutional adoption of ETFs grows and more retail investors enter the market, liquidity in even smaller ETFs is likely to improve over time.

Comparing Active Mutual Funds and Passive ETFs: The Ongoing Debate

A recurring debate in the Indian investment community is whether investors are better served by actively managed mutual funds or by passive instruments like ETFs and index funds. This is not a debate with a single right answer - both approaches have merits, and the right choice depends on the asset class, time horizon, and specific circumstances of the investor.

The Case for Passive (ETFs) The most powerful argument for passive investing through ETFs is cost. The average TER of an actively managed Indian equity mutual fund is considerably higher than that of a comparable equity ETF. Over a twenty-year horizon, paying even 1% more per annum in fees can reduce your terminal corpus very significantly. Compounding works both ways - compounding returns grows wealth, but compounding costs erodes it.

Beyond cost, there is the performance argument. Multiple studies - in India and globally - show that a large majority of actively managed large-cap equity funds fail to outperform their benchmark index consistently over five-year or ten-year rolling periods, especially after fees. The Nifty 50 or the Nifty 100 is a formidable benchmark, and most professional fund managers find it very difficult to consistently beat it over the long term. For this reason, many financial planners recommend that the large-cap portion of an investor's equity portfolio be indexed.

Passive ETFs also remove manager risk - the risk that the fund manager makes poor decisions, changes their investment style, or leaves the fund house. With an ETF, the "manager" is the index itself, which follows a transparent, rule-based methodology.

The Case for Active Management Active funds potentially shine in less efficient market segments. India's mid-cap and small-cap markets, where information may be less widely distributed and pricing may be less efficient, have historically offered more scope for skilled active fund managers to add alpha. Data over certain periods shows that active mid-cap and small-cap funds have outperformed their benchmarks more consistently than active large-cap funds, though this is not guaranteed and past performance is not indicative of future performance.

Active funds also offer the potential for downside protection. During sharp market drawdowns, a skilled fund manager can reduce equity exposure or move to defensive sectors, whereas an ETF is fully exposed to the index at all times. This active risk management can be valuable in volatile markets.

A Balanced Approach Many experienced investors and advisors in India recommend a core-satellite approach: use low-cost broad-market ETFs as the core (large-cap equity exposure) and complement with actively managed funds in mid-cap, small-cap, or international categories where active management may add more value. This hybrid approach balances the cost efficiency of passive investing with the potential alpha of active management in specific segments.

The ETF vs. active fund question is not binary. Both have a place in a thoughtful investor's toolkit, and making an informed choice requires understanding the evidence, costs, and your own investment objectives clearly.

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Example

Consider Priya, a 32-year-old software professional in Bengaluru who wants to invest ₹1,00,000 in equity markets. She has a demat and trading account with a SEBI-registered discount broker and wants broad-market exposure at low cost.

Priya identifies a Nifty 50 ETF listed on the NSE. On the day she checks, the ETF's iNAV is ₹245.30 per unit. The best ask on the order book is ₹245.50 - a premium of ₹0.20 or approximately 0.08% above the iNAV. She places a limit order for 400 units at ₹245.50, committing approximately ₹98,200 (400 × ₹245.50). Her broker charges a flat brokerage of ₹20 per trade. STT on the purchase is 0.1% of ₹98,200 = ₹98.20. Exchange transaction charges (NSE) are approximately 0.00335% of ₹98,200 ≈ ₹3.29. GST on brokerage is 18% of ₹20 = ₹3.60. Total transaction cost at entry: approximately ₹125 on a ₹98,200 investment - well under 0.15%.

The ETF's annual TER is 0.10% per annum. On ₹98,200 that works out to approximately ₹98 per year, deducted from the NAV daily in tiny increments.

Now suppose over the next three years the Nifty 50 index grows from 22,500 to 28,800 - a gain of approximately 28%. Because the ETF replicates the index (with a small tracking difference, say 0.12% per annum), the ETF's price rises by approximately 27.64% (28% minus 0.12% × 3 years = 27.64%). Priya's 400 units are now worth approximately 400 × ₹245.50 × 1.2764 ≈ ₹1,25,330.

Since she has held for more than 12 months, her gains of ₹25,330 over the original investment of ₹98,200 are treated as Long-Term Capital Gains on equity ETFs. She should refer to the latest Finance Act for the current LTCG tax rate and applicable threshold.

When she sells, similar transaction costs apply - brokerage, STT (0.1% on equity delivery sale), exchange charges, and GST. Total exit cost is again under ₹150. Over the three-year period, Priya's all-in cost of investing - TER plus transaction costs - is comfortably below 0.5% of her invested capital, which is significantly lower than what an actively managed equity fund would have cost.

Key benefits

Low Cost

ETFs, particularly passive ones, carry among the lowest expense ratios available in Indian markets, often well below 0.5% per annum. Over a long investment horizon, lower costs compound to meaningfully higher wealth in the investor's hands.

Intraday Liquidity

Unlike conventional mutual funds that transact at end-of-day NAV, ETFs can be bought and sold on the NSE or BSE at any time during market hours, giving investors price transparency and the ability to react to market conditions in real time.

Diversification in One Trade

A single Nifty 50 ETF unit gives you proportional exposure to fifty of India's largest and most liquid companies across sectors, delivering instant diversification without the need to research and select individual stocks.

Transparency

SEBI regulations require ETFs to disclose their portfolio on a daily basis and publish the Indicative NAV (iNAV) during trading hours, so investors always know exactly what they own and at what approximate value.

Flexibility Across Asset Classes

From equity indices to gold, silver, government bonds, and international markets, ETFs offer a single exchange-based format through which investors can access a wide range of asset classes, simplifying multi-asset portfolio construction.

No Fund Manager Risk

Index-tracking ETFs follow a transparent, rules-based methodology, eliminating the risk of underperformance due to poor fund manager decisions, style drift, or key-person dependency that can affect actively managed funds.

How it works

  1. 1
    Index Replication by the Fund House

    The ETF fund house constructs a portfolio that mirrors the composition of the target index - for example, the Nifty 50 - by holding the same securities in the same proportions as the index. As the index rebalances, the ETF portfolio is adjusted to match.

  2. 2
    Units Listed on NSE / BSE

    The ETF issues units that are listed on the National Stock Exchange (NSE) and/or the Bombay Stock Exchange (BSE). The iNAV of the ETF is calculated and published throughout the trading day so investors can see the fair value of the underlying basket in real time.

  3. 3
    Authorised Participants Create Units

    Large institutional participants called Authorised Participants (APs) can create new ETF units by depositing the underlying basket of securities with the fund house. In exchange, they receive a block of ETF units (a Creation Unit) which they can then sell on the exchange to investors.

  4. 4
    Retail Investors Buy on the Exchange

    Retail investors purchase ETF units on the NSE or BSE through their SEBI-registered stockbroker, just as they would buy shares, paying the prevailing market price plus standard transaction costs.

  5. 5
    Arbitrage Keeps Price Close to iNAV

    If the ETF's market price deviates significantly from its iNAV, APs step in to create or redeem units to profit from the difference, a process that simultaneously pushes the market price back toward fair value.

  6. 6
    Units Held in Demat Account

    ETF units purchased on the exchange are credited to the investor's demat account (held with CDSL or NSDL) after the standard T+1 settlement cycle, where they remain until the investor decides to sell.

  7. 7
    Investor Sells Units on the Exchange

    When the investor wants to exit, they place a sell order on the exchange. The sale proceeds are received in the trading account after T+1 settlement and then transferred to the linked bank account. Capital gains are computed based on the difference between sale and purchase prices, subject to the applicable tax provisions under the current Finance Act.

Formula 

Tracking Difference (%) = ETF Total Return (%) - Index Total Return (%) over the same period
Tracking Error = Standard Deviation of the periodic differences between ETF returns and Index returns

Key takeaways

  • An ETF is a basket of securities listed and traded on NSE or BSE throughout the day at live market prices, unlike conventional mutual funds that settle at end-of-day NAV.
  • Most Indian ETFs are passively managed, tracking an index such as the Nifty 50 or Sensex, which keeps the expense ratio very low - often below 0.50% per annum.
  • You need a demat account and a trading account with a SEBI-registered broker to invest in ETFs; KYC compliance is mandatory.
  • The creation and redemption mechanism via Authorised Participants ensures that the ETF's market price stays close to its Indicative NAV through continuous arbitrage.
  • Total cost of holding an ETF includes the TER, brokerage and statutory charges on each transaction, the bid-ask spread, and the tracking difference - not just the expense ratio.
  • Liquidity varies widely among Indian ETFs; always check average daily trading volume before investing, and use limit orders for ETFs with low volumes to avoid adverse pricing.
  • The tax treatment of ETF gains depends on whether the ETF is equity-oriented or non-equity and on the holding period; refer to the latest Finance Act for current rates.
  • ETFs are best used as core building blocks in a long-term portfolio strategy, either alone as a pure passive approach or in a core-satellite combination with actively managed funds.

Frequently asked questions

What is an ETF in simple terms?
An ETF, or Exchange-Traded Fund, is a fund that holds a collection of securities - such as all fifty stocks in the Nifty 50 - and issues units that you can buy and sell on the NSE or BSE just like a share. It combines the diversification of a mutual fund with the real-time tradability of a stock.
Do I need a demat account to invest in ETFs in India?
Yes, a demat account is mandatory to hold ETF units in India, since ETF units are held electronically just like shares. You will also need a trading account with a SEBI-registered stockbroker to place buy and sell orders on the NSE or BSE.
What is the difference between an ETF and a mutual fund?
A conventional mutual fund is transacted directly with the fund house at the end-of-day NAV and does not require a demat account. An ETF is listed on the exchange and trades at real-time market prices throughout the day, requiring a demat and trading account. Most ETFs are passively managed and have lower expense ratios than actively managed mutual funds.
Can I start a SIP in an ETF?
ETFs do not natively support the SIP mechanism the way mutual funds do, since each purchase requires a manual order on the exchange and units must be bought in whole numbers. Some brokers now offer an automated ETF-SIP feature, but it is generally less seamless than a mutual fund SIP. Investors who prefer automated, fixed-amount monthly investing often find index mutual funds more convenient.
What is tracking error in an ETF?
Tracking error is a measure of how closely an ETF replicates its underlying index. Specifically, it is the standard deviation of the periodic differences between the ETF's returns and the index's returns. A lower tracking error indicates the ETF is replicating the index more faithfully. It is different from tracking difference, which is the cumulative gap in total returns over a period.
Are ETFs safe investments?
ETFs are regulated by SEBI and are transparent, but "safe" is relative - they are subject to market risk. An equity ETF tracking the Nifty 50 will lose value when the stock market falls. Gold ETFs will fall if gold prices decline. No market-linked investment is guaranteed, and investors should assess their own risk tolerance before investing.
What is a gold ETF and how is it different from buying physical gold?
A gold ETF holds physical gold bullion with a custodian and issues units that trade on the exchange, typically representing one gram of gold per unit. Unlike physical gold, you have no storage costs, no purity concerns, and no making charges. However, you also cannot use gold ETF units as jewellery or pledge them as physical collateral. They are purely a financial investment in gold price movements.
How is an ETF taxed in India?
The tax treatment depends on the type of ETF. Equity ETFs (where at least 65% is in domestic equities) are taxed like equity mutual funds - short-term gains on units held up to 12 months and long-term gains on units held beyond 12 months, at rates specified in the current Finance Act. Non-equity ETFs such as gold, silver, and debt ETFs have different tax treatment. Always refer to the latest Finance Act for current rates.
What is an iNAV and why does it matter?
The iNAV (Indicative NAV) is the real-time estimated fair value of an ETF's underlying portfolio, calculated and disseminated throughout the trading day. It helps investors determine whether the ETF is trading at a premium or discount to the fair value of its holdings, allowing them to make more informed buy and sell decisions.
What is the minimum amount needed to invest in an ETF?
The minimum investment is the market price of one unit of the ETF on the exchange. Some ETFs have unit prices of a few hundred rupees, while others may be priced in the thousands. There is no prescribed minimum analogous to a mutual fund's minimum application amount; you simply buy at least one unit.
What happens if an ETF has low trading volume on the exchange?
Low trading volume means wide bid-ask spreads and poor liquidity. You may find it difficult to buy at a price close to the iNAV or sell without significantly moving the price. In extreme cases of very low volumes, your order may not be filled at all. For low-volume ETFs, always use limit orders and check the average daily volume before investing.
Can Indian investors use ETFs to invest in US stocks?
Yes, there are Indian ETFs listed on NSE or BSE that track international indices such as the S&P 500 or the Nasdaq 100. These are structured as fund-of-funds or as direct ETFs and allow domestic investors to gain exposure to foreign markets without opening an international brokerage account. They are subject to SEBI regulations and any applicable RBI guidelines on overseas investment.
What is the difference between an ETF's AUM and its trading volume?
AUM (Assets Under Management) is the total value of all assets held in the ETF across all investors. Trading volume is the value of units bought and sold on the exchange on a given day. An ETF can have large AUM but low trading volume if most holders are long-term institutional investors who rarely trade. For retail investors, daily trading volume is more relevant to execution quality than total AUM.
Are ETFs better than actively managed mutual funds?
There is no universal answer. Passive equity ETFs are cost-efficient and research shows that most active large-cap funds underperform their benchmark over long periods after fees. However, active funds can potentially add value in less efficient segments like mid-caps and small-caps. Many financial planners recommend a core-satellite strategy combining passive ETFs for large-cap exposure with active funds in other segments. Past performance of any fund category is not a guarantee of future results.
What is a sectoral ETF and is it suitable for all investors?
A sectoral ETF tracks an index representing a specific industry - for example, banking, pharmaceuticals, or information technology. Because all holdings are within a single sector, it carries higher concentration risk than a broad-market ETF. Sectoral ETFs are generally more suitable for investors who have a specific view on a sector and understand its dynamics, and they are typically used as satellite allocations rather than core holdings.
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