What must investors track in Exchange Traded Funds (ETFs)?

Exchange Traded Funds (ETFs) are one of the best forms of investing passively in a variety of asset classes. When we say passive investing, we are referring to a situation where there are no active fund managers sitting and taking buy/sell decisions. To that extent, the expense ratio in an ETF is substantially lower compared to a normal equity fund. Over a longer period of time, this lower expense ratio adds up to quite a bit. You have ETFs on gold, silver and also on indices like the Nifty and Sensex. An ETF differs from a typical mutual fund in the sense that an ETF is a listed security like a stock. On the contrary, mutual funds have to be redeemed with the AMC and therefore any purchase or sale impacts the AUM of the fund. On the contrary, in case of ETF buyers and sellers the AUM of the fund does not get impacted as these are market transactions.

In theory, an ETF must track the underlying asset like gold price, silver price, index value etc. Despite this relative safety that is implicit in an ETF, it is essential to understand four unique aspects of evaluating an ETF…

Zeroing down on the right index…

This is much more complex than it appears. When you buy gold ETFs, you have to choose whether you want an ETF pegged to the Indian price of gold or the dollar price of gold. The choice is critical because when you buy an ETF that is pegged to the Indian price of gold, then your gold ETF will be impacted by the international price of gold as well as by the rupee/dollar movement. In case of index ETF, it is essential to select the index based on the theme that you choose to play on. If you want to take a passive view on the overall Indian economy then the Nifty or Sensex ETF will be the best bet. If your are taking a view on equity as an asset class, then a more broad-based index like the Nifty 500 will be the ideal underlying index for the ETF. The most critical choice is the specific underlying on which you need an ETF and that should perfectly gel with your investment goal.

Focus on expense ratios…

It is quite simplistic to say that ETFs have an expense ratio that is lower than normal mutual funds. That is a known fact. However, even within ETFs, there are variations in cost structure, just as there are variations among mutual funds in their expense ratio. Always prefer an ETF that has a lower expense ratio. Remember, an ETF does not require higher skill in active management and hence their transaction costs should be low and fund management fees should be much lower.

Keep a tab on the tracking error…

This is a fairly interesting measure that is relevant for ETFs and also for index funds. So what exactly is the tracking error? As the name suggests, tracking error is the extent to which the ETF value tracks the underlying index. Lower the tracking error, the better the ETF is tracking the underlying. Conversely, if the tracking error is too high then it means that the ETF is not able to appropriately track the underlying. Obviously, you must prefer the ETF with a lower tracking error as your focus in an ETF is to be as close to the price of the underlying, be it gold, silver or any market index. The next question is why does tracking error arise? Firstly, there is an expense that gets debited to the fund and that distorts from the value of the underlying. Secondly, the underlying portfolio shifts may have a time lag and hence price changes may happen during this period which will result in tracking error.

The size and liquidity of the ETF is important…

This may sound simple but you cannot underplay this aspect. Globally, the benchmark is that you must prefer an ETF that has an AUM of at least $100 million. In the Indian context, one can take Rs.100 crore as the cut-off for selecting an ETF. Don’t jump into brand new ETFs. Wait for these funds to attain a minimum corpus of Rs.100 crore before venturing into that fund. Most ETFs offer market trades for small orders and direct sale for large orders. It is always better to go with reputed names as they will be able to manage HNI redemptions better compared to smaller funds. Another aspect to focus on is the secondary market liquidity. The beauty of the ETF is that it closely tracks the price of the underlying and therefore you get returns that mirror the underlying. However, if the ETF is not liquid in the market then bid-ask spreads will be too wide and this will distort the price that you will get. There is a large liquidity penalty that you will have to pay in case the ETF is not traded broadly on a regular basis.

In a nutshell, even though an ETF is a passive investment, there are some critical features that you need to understand with respect to ETFs. Understanding unique aspects like index selection, tracking error, expense ratio measurement and liquidity will go a long way in ensuring that your ETF better reflects the value of the underlying that you are trying to bet on!

One response

  1. Nice article and quite fundamental perspective explained in a simple manner..

    Can you please suggest a good GOLD ETF in Indian currency which can take care of next 5 year and i would like to invest in SIP manner.

    Thank you

    Like

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