Exchange-traded funds (ETFs) are investment vehicles that hold a collection of securities, such as stocks, bonds, or commodities. They can be bought and sold like individual stocks on a stock exchange and offer a convenient and low-cost way to invest in a diverse range of assets. ETFs are often designed to track the performance of a specific index, such as the Nifty 50 and are considered as passive investment vehicles. An ideal ETF must be able to replicate the underlying benchmark index efficiently, meaning that the ETF’s Net Asset Value (NAV) and price move in tandem with that of the index. ETFs can be a good choice for investors wanting to invest in the benchmark indices while paying very low expense costs. However, in order to invest in ETFs, it is necessary to hold a demat account.
Choosing the right ETF:
Choosing the right ETF can be an important decision for investors, as it can help ensure that the fund aligns with your investment goals and risk tolerance. Here are some steps to consider when choosing an ETF.
Tracking error is a measure of how closely the performance of an ETF tracks the performance of its benchmark index. It is calculated as the standard deviation of the difference between the fund's return and the benchmark's return over a given period of time.
Investors often use tracking error as a measure of the quality of an ETF or index fund. A lower tracking error indicates that the fund is performing more closely to its benchmark, while a higher tracking error indicates that the fund is deviating more from its benchmark. For example, if an ETF tracks the S&P BSE Sensex index and has a tracking error of 1%, this means that the ETF's returns are expected to deviate from the S&P BSE Sensex’s returns by about 1% on average. Thus, the lower the error, the better is the performance of the fund.
However, it's important to note that tracking error is not the only factor to consider when evaluating an ETF. Other factors such as expenses, diversification and liquidity should also be taken into account.
Impact cost is the indirect cost associated with executing a trade on an exchange. With respect to ETFs, it is the difference between the price at which an investor wanted to buy or sell an ETF and the price at which the trade was actually executed. Impact cost can be caused by several factors, including the liquidity of the asset, the size of the trade, and the market conditions at the time of the trade.
It is important for investors to consider impact cost when evaluating an ETF, as it can affect the overall returns of the investment. In general, impact cost is higher for less liquid ETFs which do not have sufficient volume needed to be absorbed by the market. Conversely, impact cost is lower for highly liquid ETFs as trades can be easily absorbed by the market.
The expense ratio is an important factor to consider when evaluating an ETF, as it reflects the annual costs of owning the fund. The expense ratio is expressed as a percentage of the fund's assets and is calculated by dividing the total expenses of the fund by the total assets of the fund. The total expenses of the fund include management fees, administrative charges, operating expenses and all other asset-based costs.
A lower expense ratio generally indicates that the fund is cheaper to own, as it incurs fewer expenses. Conversely, a higher expense ratio may indicate that the fund is more expensive to own, as it incurs higher expenses.
It is generally a good idea for investors to choose ETFs that are highly liquid, as this can make it easier and more cost-effective to buy and sell the fund. Liquidity refers to the ease with which an ETF can be bought or sold on the market. ETFs that are highly liquid tend to have smaller spreads between the bid and ask prices, which can result in lower trading costs for investors.
Historical or past performance is a useful indicator of how an ETF has performed in the past, but it is important to note that past performance is not necessarily indicative of future results.
Conclusion
ETFs offer investors the ability to invest in a wide variety of indices and asset classes and can be purchased with a small minimum investment. They also offer liquidity, as they can be bought and sold on an exchange throughout the trading day. ETFs are less volatile than equity diversified funds and hence are suitable for risk averse investors. Investors who already hold a demat account and transact on stock exchanges can easily invest in ETFs.
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