For active investors or traders who frequently buy and sell stocks, parking funds in a broking account is convenient. However, funds in these accounts don’t yield any interest.
Instead, one can consider using liquid ETFs or exchange-traded funds to earn interest. If your broker allows it, you can simultaneously sell liquid ETF units to buy stocks and vice-versa.
How liquid ETFs work
To understand how liquid ETFs work, we need to understand Treps or tri-party repos, as this is where these ETFs gain exposure. Treps is an arrangement used for short-term borrowing and lending.
Liquid ETFs invest in Treps with a one-day maturity. A borrower pledges government securities (treasury bills) to a lender in exchange for funds. The borrower agrees to repurchase the securities at a specified future date, repaying the principal along with accrued interest. These transactions are generally short-term, ranging from overnight to a few weeks, and are commonly used to address short-term liquidity requirements of institutions.
Given their short-term maturity and use of government securities as underlying assets, these instruments offer higher liquidity. Treps are typically traded on the Clearing Corp of India Ltd.
“Since it is a short-term overnight instrument with one-day maturity, there is minimal interest rate risk,” said Anil Ghelani, head of passive investments and products, DSP Mutual Fund.
Bonds with longer maturity are more sensitive to interest rate movements, while the shorter the maturity, the least sensitivity to interest rate movements.
Liquid ETFs offer better returns than bank savings accounts, typically in the range of 5.75-6% per annum.
A trader or investor can sell stocks and buy liquid ETF units simultaneously on the same day and vice-versa. On a T+1 basis, stocks are debited from the demat account, and on T+1, liquid ETF units are credited, allowing the investor to start earning returns immediately.
“The new rules let you use 100% of your sale proceeds for the next trade right away. Earlier, it was tricky for brokers to allow as full credit wasn’t available across all segments,” said Mohit Mehra, vice president, primary markets and payments at Zerodha.
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Types of liquid ETFs
At present, there are two types of liquid ETFs: dividend-based NAV (net asset value) and growth NAV.
In dividend-based NAV (net asset value), the returns are generated as daily dividends and reinvested into the ETF. These reinvested units are credited to the investor’s demat account as fractional units on a weekly, bi-weekly or monthly basis. The frequency will depend on the fund house managing the ETF. As additional returns come through dividends, the ETF’s NAV is maintained at ₹1,000.
Until the dividend units accumulate to at least one whole unit, they don’t reflect on broking platforms. Investors can verify these units in the holding statement of the depository. Fractional units cannot be sold directly on stock exchanges, and one of the options is to transfer to the mutual fund’s demat account through an off-market transfer.
Determining returns can be tricky as you’d need to compute the rate at which the dividends are issued. Dividends are taxed at the slab rate of investors. Hence, investors need to track the fractional units to determine their final tax liability. To be sure, dividends were tax-free when dividend NAV liquid ETFs were launched.
A growth NAV liquid ETF has no dividend or reinvestment option, eliminating the challenge of dealing with fractional units. Gains are added directly to the NAV. In terms of taxation, capital gains are taxed at the investor’s slab rate.
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Takeaways
Investors can opt for growth NAV liquid ETFs to avoid the challenge of dealing with fractional units. However, when investing in growth NAV ETFs, check the iNAVs (intraday NAVs) of these ETFs to ensure that you are buying and selling these ETFs at fair value—not at a steep premium or discount. iNAVs are issued by the fund house at regular intervals during the day, which indicates the fair value of the ETF.
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