What Is an ETF and How Does It Work? A Guide for Indian Investors

Huzefa Kudrati Jun 24, 2023 Updated Oct 3, 2026 8 min read

An ETF (exchange-traded fund) is a fund that holds a basket of assets, usually the stocks in an index such as the NIFTY 50, and trades on the stock exchange like a single share. You buy and sell ETF units through your broker during market hours at the live price, hold them in your demat account, and get the returns of the whole basket, minus a small annual fee.

How does an ETF work?

A fund house launches the ETF with a clear mandate, for example "track the NIFTY 50".
It holds the underlying assets in the same proportion as the index (or holds gold, bonds and so on).
The ETF is listed on the exchange. You buy and sell units through your broker like a share, and they sit in your demat account.
Market makers keep the price close to the value of the holdings. They can create new units or redeem existing ones with the fund house, which pulls the market price back towards the fund's net asset value (NAV) when it drifts.
The fund charges a yearly expense ratio, taken out of the fund's value daily, not billed to you separately.

ETF vs mutual fund vs index fund

	ETF	Index mutual fund	Active mutual fund
How you buy	On the exchange through a broker	From the fund house or a platform	From the fund house or a platform
Price	Live market price during the day	NAV, once a day	NAV, once a day
Demat account needed	Yes	No	No
SIP	Possible through some brokers	Yes	Yes
Management	Usually passive	Passive	Active stock-picking
Costs	Usually lowest expense ratio, plus brokerage and spread	Low	Higher
Main risk beyond the market	Low trading volume, price away from NAV	Tracking error	Manager underperforms

If you already have a demat account and want low costs and intraday flexibility, ETFs fit well. If you want automatic monthly investing without thinking about prices, an index fund SIP is simpler.

Types of ETFs in India

Broad index ETFs: NIFTY 50, SENSEX, NIFTY Next 50. The core holding for many investors.
Mid-cap and small-cap ETFs: track indices of smaller companies, such as the NIFTY Midcap 150.
Sector and thematic ETFs: banking, IT, PSU, consumption and other themes. Concentrated, so riskier.
Factor (smart beta) ETFs: select stocks by rules such as momentum, low volatility, quality or value.
Gold and silver ETFs: track the price of the metal without you storing it.
Debt ETFs: government securities, PSU bonds, or overnight money (liquid ETFs).
International ETFs: track foreign indices such as the NASDAQ 100, giving exposure to overseas markets in rupees.

Mid-cap ETFs: more growth, more swings

SEBI classifies the 101st to 250th largest listed companies by market capitalisation as mid caps (the top 100 are large caps). Mid-cap ETFs hold baskets of these companies.

Pros of mid-cap ETFs

Exposure to companies with more room to grow than large caps
Diversified across many mid-sized companies and sectors in one unit
No need to research individual mid-cap stocks
Low cost compared with active mid-cap funds

Cons of mid-cap ETFs

Larger falls than large-cap indices in market corrections
Can lag large caps for long stretches
Some mid-cap ETFs have low trading volumes and wider spreads
Not a substitute for a core large-cap or broad-market holding

A common approach is a large-cap or broad-market ETF as the core, with a smaller allocation to mid caps sized to how much volatility you can live with.

Benefits of ETFs

Instant diversification: one unit, dozens of companies.
Low cost: passive ETFs often have expense ratios well below active funds.
Transparency: holdings are disclosed and follow a published index.
Trade any time during market hours with limit orders, like a share.
Small ticket size: you can buy a single unit.

Costs matter more than they look, because they compound:

Line chart: ₹10 lakh over 20 years at a hypothetical 10% gross return grows to about ₹66.6 lakh with 0.05% annual costs, ₹60.9 lakh with 0.5%, and ₹49.7 lakh with 1.5% Illustration of cost drag; real returns vary and can be negative

Risks and drawbacks of ETFs

Market risk: a NIFTY ETF falls when NIFTY falls. Diversification spreads company risk, not market risk.
Liquidity risk: some ETFs trade thinly. Wide bid-ask spreads mean you can pay noticeably more than the fund's value when buying, and get less when selling.
Price away from NAV: in thin or fast markets, the ETF's price can drift from its indicative NAV (iNAV).
Tracking error: the ETF's return can differ slightly from the index because of costs, cash holdings and rebalancing.
Concentration: sector and thematic ETFs can be as risky as a handful of stocks.

How to choose an ETF

Decide what exposure you want: broad market, mid caps, a sector, gold or bonds.
Compare ETFs tracking the same index on expense ratio and tracking error.
Check liquidity: average daily traded value and the bid-ask spread. Higher volume usually means fairer prices.
Look at the fund size (AUM): very small ETFs can be less liquid.
Understand the tax treatment: equity ETFs are taxed like listed shares; other ETFs follow different rules. Check current rules before investing.

Do ETFs pay dividends?

Some do. An equity ETF receives dividends from the companies it holds; depending on the fund, it either pays them out to unit holders or keeps them in the fund (which shows up in the unit's value). Many Indian index ETFs reinvest rather than pay out, so check the scheme details if you want regular income.

Investing in ETFs by rules

Because ETFs trade like shares, they work well in rules-based strategies: a monthly buy plan, a trend filter that moves between an equity ETF and a liquid ETF, or rebalancing between equity and gold.

Frequently asked questions

What is an ETF in simple words?

An ETF is a fund that holds a basket of assets, such as all the stocks in the NIFTY 50, and trades on the stock exchange like a single share. Buying one unit gives you a small slice of the whole basket.

How is an ETF different from a mutual fund?

You buy ETF units on the exchange at live prices during market hours and need a demat account. Mutual fund units are bought from the fund house once a day at NAV. ETFs are usually passive and have lower expense ratios.

Do I need a demat account to buy ETFs?

Yes. ETFs are listed securities, so you buy them through a broker and hold them in your demat account. If you don't have one, index mutual funds offer similar exposure without it.

What is a mid-cap ETF?

An ETF that tracks an index of mid-sized companies, which SEBI defines as the 101st to 250th largest listed companies by market capitalisation. It offers more growth potential than large caps, with bigger swings.

Are ETFs safe for beginners?

Broad index ETFs are one of the simplest ways to start, because they spread money across many companies at low cost. They still fall with the market, and sector or small-cap ETFs are much riskier.

Can I trade ETFs intraday?

Yes. ETFs trade like shares, so you can buy and sell them during the day. Most investors use them for long-term holding, and thinly traded ETFs can have wide spreads that make frequent trading costly.