Your Queries: Mutual Funds | Passive funds carry security concentration risks & exchange-related liquidity risks

I am planning to invest in exchange traded funds (ETFs) as the costs are lower than actively managed funds. What are the risks involved in ETFs?
— Deepak Ohri

Exchange traded funds (ETFs) are passively managed funds, in that they track/replicate an index by investing in the same securities as that in the index and in exactly the same proportion. ETFs save on the research costs and also the registrar & transfer agent (R&T) costs. Hence, the cost involved is much lower than that of active funds. However, investing in ETFs entails the costs of maintaining a demat account and a brokerage charge on traded value. ETFs trade continuously throughout the day like stocks based on the bid-ask price at that instant in the exchange order book, and hence the price of an ETF may deviate from the price of the underlying basket of securities.

Passive funds carry risks such as security concentration risks and exchange-related liquidity risks. If the underlying index has no cap on security level weights, the index may turn out to have high concentration of select top performing securities, which exposes an investor to the company specific risks of that security. Also, exchange-related liquidity risk is crucial since despite the low costs of the ETF, an adverse bid-ask spread may work against investor interest having a big impact at exit.

I have been investing in gold ETFs and gold FoFs for over three years. How do I calculate tax on the gains?
— Anurag Mehta

Gold ETFs involve creation of units against physical gold that these ETFs purchase in order to track the price movement of gold. Gold FoF (fund-of-funds) invest into gold ETFs and impose an additional layer of expenses in addition to the expense ratio of the underlying ETF. A demat & a trading account are required for investing into ETFs. Both are taxed in a manner similar to that of physical gold. For gains for a holding period of up to three years, the ‘short-term gains’ are added to income and taxed at the marginal tax rate. For holding periods of over three years, ‘long-term gains’ are taxed at 20.8% (including cess) post indexation of costs.

The writer is director, Investment Advisory, Morningstar Investment Adviser (India). Send your queries to [email protected].