What you should know before investing in ETF?

Looking for low cost investment vehicle? Then try ETF (exchange traded fund). It is a close relative of the mutual fund and tracks the value of its underlying asset.

The underlying assets could be assets, commodities and bonds. So you have index ETFs that track the performance of its benchmark index, gold ETFs amongst the commodity ETF that have managed to give outstanding performance and liquid ETF amongst bond category that has investments in money market instruments.

But with over 100 index ETFs, 6 gold ETFs and one liquid ETF, the question that arises, how should you choose the right one for your investment?

If you are in such a dilemma, then here are some important criteria to help you with selection:

Select ETF having a single portfolio: Go through the portfolios of the ETFs that you are considering and choose the one whose portfolio is concentrated on a single asset class.

E.g. if you want to invest in an index ETF, find out if it solely focuses on equities or does it even invest a big portion of its corpus in debt. If it does, the returns will be diluted as debt will not be able to match the returns from the equities. For this, go through the offer document. Also avoid lesser know ETFs, as they may not give you ample liquidity or may not be traded at all.

NAV issues: It is very essential to find out if the units of ETF are sold at a discount to shares. It is possible that though the performance of the shares is superlative, the ETF units may be available at a price lower than the market price of the shares. E.g. if the price of a unit is Rs. 5000 on Nifty, find out if the ETF is listing its price below Rs. 4900. Avoid these types of ETFs, as the difference keeps on increasing. As the difference keeps on going up, the investor ends up losing his money.

In order to avoid such a situation, check the order book of NSE, which lists the prices and number of units sold. Also find out if the ETF generates new units or at least sells them to meet a mismatch in a demand or supply in the market. If it happens, the issue of discount can be avoided.

Tracking error: A good tracking error must have low tracking error. The difference between the price of ETF and its bench mark index is called tracking error. E.g. if the index goes up by 50%, an investment of Rs. 1000 in an ETF, may not become Rs. 1500, but can become Rs. 1200. This difference is due to tracking error. The main cause of tracking error is high fund management charges. It can also occur if the ETF keeps cash for meeting redemption requests or paying dividends.

Liquidity: This is the most important point. Is the ETF traded regularly on the bourses? Does it mean there are sufficient buyers and sellers for the ETF? If the ETF is not traded regularly, you will not be able to sell your investments if you so desire. If a bonus or dividend has been declared by the ETF, did it show up as the returns to the investor? Liquidity is the most essential aspect of investing in an ETF.

Bid/ask spread: Does the ETF have a low bid/ask spread? Bid implies the price at which the investor can purchase the units and ask implies the price the seller is ready to sell his units. Ensure the difference is as low as possible. You can get this information from the fund chart.

ETF expenses: Expenses are very important factor to consider as they can affect the returns. Of all the expenses, brokerage is the most important one. The fund incurs brokerage whenever the units are bought or sold. Excessive trading or churning portfolio regularly incurs costs. So always look around for discount brokers as their commission is low and they usually work online.

Choose an ETF where the brokerage costs are 0.3%. Other expenses include management charges, trustee fees, investor communication fees, audit fees, account statements charges, listing, license, marketing and selling expenses and operating expenses. These expenses do add up and lower your expense. Select the fund with the lowest expense.

Another expense you will incur is demat, which is mandatory for investing in ETF. If you already have one, you can use the same for buying ETF units. If not, shop around to get the demat account having zero annual maintenance charges or not charging account opening fee. If not, go for a demat account, charging a flat fee or charges brokerage fee only the traded volume.

ETFs are low cost investment vehicles. However they do have certain hidden charges, that if ignored can affect the returns. You need to watch out for various factors that can impact the performance of the fund. These factors include tracking errors, NAV discount, bid/ask spread, liquidity and portfolio besides hosts of other expenses. Look at al these factors carefully, before investing in an ETF.

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