ETFs are low cost, passive investment products that are gaining currency all over the world including India. There are more than 70 ETFs in India. In the last 3 years, more than 30 ETFs have been launched. Most ETFs in India track domestic equity indexes but there are few ETFs which also track foreign equity indexes and also price of gold. There are also a few ETFs which invest in fixed income e.g. G-Secs, money market etc. In this chapter, we will discuss different factors to consider before choosing ETFs.

Identify the index

To discuss how to pick the best ETF, this could be the most important consideration in selecting an ETF because ETFs track respective indexes. The difference in performance of two ETFs following the same index is only the relative tracking errors, which we will discuss later in this chapter. You should follow a methodical approach in identifying index. Firstly, you need to decide on the asset class i.e. equity, fixed income and gold when investing in ETFs. Asset class will depend on asset allocation needs, your risk profile and financial goals. You should consult with your financial advisor to know your risk profile and asset allocation needs.

Secondly, once you have decided on asset class, you should then identify asset sub-categories. For example, in equity you can have large cap, midcap, banking sector, PSUs ETFs etc. In fixed income you can have G-Secs, Liquid, PSU bonds etc ETFs. You should always take a portfolio view when selecting an asset class or sub-category. Your investment decision can be based on your risk profile, portfolio diversification needs, liquidity needs and other considerations. 

Finally, within an asset sub-category you need to determine which index gives you best exposure to the asset sub-category, based on your risk appetite and investment needs. For example, within large cap equity, you can invest in BSE Sensex, Nifty 50, Nifty Next 50 and NSE 100 / BSE 100. Here again you need to take a portfolio view. For example, if you want to lower the volatility of your equity portfolio you may want to invest in Sensex or Nifty. On the other hand, if you think you have high exposure to Nifty 50 in your existing portfolio, you may want to diversify your portfolio by investing in Nifty Next 50. These are just two examples. You should invest according to your specific needs and risk appetites. But if you still have some question to know how to choose ETFs for your portfolio, a financial advisor may help you.

Tracking error

Tracking error is the deviation of the ETF returns from the index returns. You should always invest in an ETF which has low tracking error, i.e. the ETF returns replicate the index returns as much as possible. A big source of tracking error is Total Expense Ratio (TER) of the ETF. An ETF with low TER is likely to have low tracking error.

Another source of tracking error can be the amount of cash held by the ETF and for how long. Cash held by an ETF is the money which has not yet been deployed in the basket of securities of the underlying index of the ETF. While TER can give you a good indication of the potential tracking error, you should also monitor the tracking error i.e. difference in index returns and ETF returns over different periods and invest in a fund with low tracking error. You can consult with a financial advisor if you need help in assessing the tracking error of your ETF.

Liquidity

The importance of liquidity in ETFs is often understated, but in a market like ours liquidity should be a very important consideration. Unless you are investing very large amounts in ETFs (in lot sizes specified by the AMC) you can sell your ETF units only on stock exchanges. To sell your ETF units in the stock exchanges you need to find a buyer; if you do not get a buyer, you may not be able to sell your units.

AMCs appoint Authorized Participants as market makers in ETFs. Market makers try to ensure sufficient liquidity for ETFs and as close to fair price (NAV) as possible for investors (buyers or sellers). However, the efficiency of Authorized Participants (APs) as market makers differs from one AP to another. If your ETF is not very liquid, you may have to sell your ETF units at a price significantly lower than the NAV or in extreme situations may not be able to sell when you want to sell.

The premium or discount of the market price of an ETF to its NAV is usually a good indicator of liquidity. Highly liquid ETFs have low premium or discount to NAV. You can also look at the trading volumes data of the ETF. An ETF with high trading volumes is more liquid. Price and volume data of ETFs is available from the stock exchange and the NAVs are available on the mutual fund’s website. You should look at this data and make informed investment decision. Liquidity is an important factor that you should look at before investing in ETFs.