In How ETFs work, I explained some basics of Exchange Traded Funds, or ETFs.
Here I look at a few parameters one must keep in mind when selecting such investments. Just because they are passive investments doesn’t mean they are all identical or even similar. Also, there are a large number to choose from. As of January 2021, there are more than 80 ETFs (excluding Gold ETFs) in India which collectively manage assets worth Rs 2.56 lakh crore.
Each fund house offers multiple ETFs which are designed to track different indices and strategies. So selecting the right ETF can be a herculean task.
Here’s a handy checklist.
This is the difference between a portfolio’s returns and the return of the benchmark/index it is mimicking.
The aim of the ETFs is to track the index constituents and attempt to deliver identical returns. Tracking error points to the discrepancy between the ETF performance and index performance.
This can be caused by a variety of reasons such as cash held by the ETF, time lag in investing dividends, rebalancing due to exit and entry of stocks from index, corporate actions, and so on. Fund houses strive to keep the cash position low in order to match the index returns.
Choose funds that have low tracking error.
ETFs are not only for passive investors
ETFs are not widely popular among investors in India and illiquidity is a relevant concern. If there aren’t enough buyers for your trade, you may not get your desired price if the ETF is illiquid.
ETFs have two layers of liquidity: liquidity of the underlying securities (primary market), and the liquidity of the ETF units traded (secondary market). Liquidity is provided by market makers who take the opposite side of the trade by buying and selling ETF units.
One way to ascertain the liquidity of any ETF is by looking at its trading volumes. Low trading volumes could widen the bid-ask spread, while high trading volume will narrow this spread. Bid is the price you are willing to pay and ask is the price seller quotes.
Consider ETFs where trading volumes are high.
Opting for a passive portfolio
ETFs are an inexpensive way to participate in market. All types of funds charge an expense ratio which gets deducted from the fund’s gross returns. In India, active funds are allowed to charge up to 2.25% for equity funds, which comes down as the fund’s assets under management increase. Since the costs associated with running passive funds is less in comparison to active funds, the TER is capped at 1%.
The TER varies across index funds and ETFs according to the fund’s investment style and strategy. A plain vanilla ETF tracking the Nifty or Sensex would charge less in comparison to say a smart beta ETF which would churn the portfolio in sync with the investment objective. You should choose a fund with lower TER. However, the expense ratio should not be the sole criteria while choosing funds though and should be looked at in conjunction with the above factors. Index funds have slightly higher expense ratio in comparison to ETFs as index funds can be bought from the fund house as well as distributors.
Active or Passive: Which is better?
Ask yourself why you are investing in it.
If you are using it as a base for your portfolio, opt for a broad Sensex/Nifty. An ETF tracking a wider index will give you the benefit of diversification. A narrow sectoral index, such as infrastructure or healthcare, can be used to make tactical calls.
Study the investment objective and the strategy of the ETF before making an investment decision. It should be in sync with your overall strategic asset allocation. Choose an ETF which can add value to your existing portfolio.
ETFs invest in both equity and debt securities. The options for debt exposure through ETFs are limited. In equity, you have a wide variety of options like large cap, mid cap, small cap, Gold ETFs, smart beta ETFs, ESG, thematic/sectoral indices and so on.
How ETFs work and their types
- Assets Under Management, AUM
Ideally, go for ETFs which have a higher AUM. While this indicates the level of investor interest in the fund, it is not just the popularity in itself that is a telling indicator. A large AUM enables funds to cut costs and pass them on to investors by way of a lower TER. A lower TER means higher returns. Which is what every investor ultimately wants.
Should you opt for an active or passive fund?