Why do you need a demat account for investing in ETFs?

Why do you need a demat account for investing in ETFs?

Mutual funds are a pool of professionally managed funds which are further categorized based on their unique features like investment objective, investment strategy, risk profile, etc. This categorization has been done so that investors are able to take an informed investment decision. Investors can now diversify their mutual fund portfolio depending on their risk appetite rather than depending on any one asset class for income generation. Some of the major mutual fund categories include equity, debt, hybrid, solution oriented, gold, index, and ETFs (exchange traded funds).

Securities and Exchange Board of India (SEBI), the regulator of securities and commodities in India describe exchange traded funds as – “is an open ended scheme which replicates/tracks the particular index. Of the total assets, this fund must invest a minimum of 95 per cent in securities of a particular index (which is being replicated or tracked)”.

To put it in simple words, an exchange traded fund (ETF) mimics the performance of a particular benchmark/index / commodity for example, the NIFTY 100 or gold. Unlike actively managed funds,ETFs do not involve the active participation of the fund manager. While mutual funds are only traded once after the market closes, ETFs can be traded throughout the market day when the exchange is open. The NAV of ETFs fluctuate like company stocks at the exchange. NAV of mutual funds may or may not change every day.

On the contrary, unlike an index fund, ETFs are marketable securities which can be bought/sold and traded just like any other company stock throughout the day at an exchange. Another thing that differentiates an ETF from mutual funds is that it does not have net asset value or NAV like mutual funds. Just like an equity share, one unit of an ETF is equivalent to one share of its underlying index.

Why do investors need demat account for buying / selling ETF units?

A demat (short for dematerialization) account is used in the process of holding investments like shares, government bonds, etc. Investors who buy / sell shares need two accounts – a trading account and a demat account. A trading account is used to buy / or sell securities. Investors who buy shares using a trading account have them stored in the demat account. Similarly, when the investor has to sell their shares these are taken away from their demat account and sold to the company.

Now since ETFs function just like traded stocks, it is essential for investors to have a demat account for storing the units that they will be buying using the trading account.The good thing about owning a demat account is that even though you are getting one for investing in ETFs, you can even maximize its use later for trading shares and other securities.

Things to consider before investing in ETFs

Exchange traded funds are highly volatile in nature. Their price per share value fluctuates just like any other company stock. They do not offer any diversification like other mutual fund schemes. Investors must keep these things in mind while making an investment decision.

ETFs are more reasonable as compared to actively managed mutual funds because they carry a low expense ratio. The expense ratio of actively managed funds is more because there the fund manager is responsible for buying / selling securities in quantum with the asset allocation strategy. But there is not major involvement in ETFs as the scheme mimics the performance of its benchmark with minimum tracking error, the expense ratio of ETFs is always low.

Bonnie Baldwin