How to Select ETFs

A number of investors are warming up to a distinct category of mutual funds: the exchange-traded funds (ETFs). After the Government of India’s successful divestment of select Maharatna and Navratna public sector units (PSUs) through India’s first Central Public Sector Enterprises (CPSE) ETF in March 2014, and the increase in investment of retirement funds in equity through ETFs, these funds have emerged as a fast-growing category. The CPSE ETF was based on an index of 10 Maharatna and Navratna PSUs. It was launched in March 2014 at a net asset value (NAV) of Rs17.45 per unit, and was over-subscribed. After the initial success, the government offered two further tranches in the first quarter of this calendar year. Both were heavily over-subscribed. All categories of investors—anchor, retail, and institutional—participated. For investors in ETFs, the past has proven rewarding. This is among the reasons why in the past 3 years, the assets under management (AUM) of ETFs in India have grown almost four-fold, from Rs13,528 crore in March 2014 to Rs53,533 crore as of June 2017. Across the world, too, ETFs are one of the largest categories. In the US, from a $218 billion AUM in 2003, they have grown manifold to the current $3.9 trillion, a near 25% compounded annual growth rate over 14 years. 

 In the US, nine of the top-25 traded securities are ETFs. The top-traded security on the New York Stock Exchange (NYSE) is the SPDR S&P 500 ETF, by value over $20 billion daily. An ETF is essentially a mutual fund scheme that trades on the stock exchange like a share. It can hold in its underlying portfolio either a commodity, fixed-income or a basket of equity shares. For example, index ETFs are popular because they mimic an index, such as the Nifty, holding similar shares in similar proportions as in the index. 

 As ETFs are traded on an exchange, an investor obtains the benefit of diversification in one single trade plus trading flexibility or real-time pricing of a stock. 

 In India, investors have a wide choice of ETFs based on Nifty and Sensex, Nifty 100, and S&P BSE 100 ETF, among others.

Even sector-wise ETFs—banking, thematic or strategic trends like consumption, dividend opportunities, or infrastructure—are part of the offerings. The government divestment ETFs have been well-received, and also others such as money-market ETFs, government securities ETFs and commodity ETFs such as gold.  

What, then, are the key factors that investors should look at before investing in ETFs? 

Is your ETF liquid enough? If an ETF has enough liquidity, it’s easy for investors to buy or sell on the stock exchange. This means that there should be enough trading volumes of the ETF on the exchanges during the day. Generally, ETFs with a larger investor base have higher liquidity on the exchange. Simultaneously, the underlying assets that the ETFs own should also have ample liquidity, enabling the fund to effectively invest in those underlying assets, with a low cost of buying shares.  

Lower tracking error: This is an important yardstick of measuring the performance of ETFs against their own benchmarks. In simple language, the difference in returns between an ETF and its benchmark is known as a tracking error. The lower the tracking error, the closer the returns of an ETF to that of the benchmark index. Tracking error is calculated with the total returns benchmark index, which shows returns of the underlying index constituents, inclusive of dividend. Investors should look at consistently low tracking error over long periods of the scheme’s existence.

Soft impact cost: This is an indirect cost of executing a transaction on an exchange. Higher the liquidity, lower the impact cost and therefore lesser the indirect cost to investors. When you execute such orders, chances are that the underlying security will fluctuate and, therefore, increase your purchase costs. Say, you want to purchase 5,000 units of an ETF. The National Stock exchange (NSE) terminal shows a best-buy order of 1,000 ETF units at Rs980 and a best-sell order for 2,000 ETF units at Rs982. Hence, your ideal price should be the average, Rs981. But if you were able to buy 5,000 shares of that ETF at an average of Rs991, your impact cost is 1%: (991-981)/981. This means you incurred an indirect transaction cost of 1% to buy 5,000 shares because of the liquidity in that stock. Liquid stocks have low impact cost. So, watch out for this cost.  

Low expense ratio: The annual charges of an ETF are shown in its expense ratios. This includes fund expenses, including: management fees, administrative fees, operating costs and all other asset-based costs incurred. Currently, Nifty- or Sensex-based ETFs are available from most of the leading fund houses at 5-10 basis points, and a banking ETF at 15-20 basis points. However, one should not see expense ratios in isolation, but also see liquidity and historical track record. (One basis point is one-hundredth of a percentage point.)

Liqudity and historical track record: By and large, most ETFs have lower costs than other equity funds because of the passive nature of the fund, and the fact that their structure closely follows an index. ETFs offer investors a way to strategic diversification of portfolios at much lower costs.