The essential guide to choosing the right ETF

Exchange-traded funds (ETFs) have surged in popularity in recent years. Since these passive funds track an underlying index, say the Sensex or Nifty, they offer low-cost exposure to a diversified range of assets. This makes them an attractive option for many investors, particularly those looking to build long-term wealth without actively managing their investments.

However, with over 230 ETFs currently available in the market, selecting the right one can be a daunting task. While ETFs are often seen as an easy way to invest, choosing the wrong ETF can lead to suboptimal returns or unnecessary costs. Sometimes, you may even find it tough to sell your investment in the fund.

So, to help you navigate the world of ETFs, we've put together a comprehensive guide to the most critical factors you should consider before making your choice.

Factors to consider when investing in ETFs

1. The index tracked by the ETF

An ETF (Exchange-Traded Fund) is designed to track an index, which is essentially a collection of stocks, bonds or other assets. This means that when you invest in an ETF, you are indirectly investing in all the assets that the index includes. For example, if an ETF tracks the NASDAQ 100, it invests in the top 100 non-financial most actively traded companies listed on the Nasdaq stock exchange. Understanding the index is crucial because it will help you know what you're actually investing in and whether it aligns with your financial goals. It's like choosing a playlist of songs—you want to make sure the music (or in this case, the investments) matches your taste (or investment goals).

2. Tracking error

Tracking error is a way to measure how well the ETF is following the performance of the index it is supposed to track. Ideally, the ETF's performance should match the index closely.

A low tracking error means the ETF is doing a great job of tracking the index, while a high tracking error means it may not be following it accurately, which can hurt your investment returns.

3. Liquidity

Liquidity refers to how easily you can buy or sell the ETF without affecting its price too much.

If an ETF is highly liquid, it means there are lots of buyers and sellers, making it easy for you to buy or sell whenever you need to. This is important because if an ETF has low liquidity, you might find it hard to sell your shares.

High liquidity in ETFs is like being in a crowded market. There are plenty of buyers and sellers, so you can easily buy or sell units at a fair price. Low liquidity, on the other hand, is like being in an empty market. You may struggle to find a buyer when you want to sell and might have to lower your price or wait longer to complete the transaction.

4. Difference between ETF price and NAV

Every ETF has a net asset value (NAV), which is the total value of the assets in the fund, divided by the number of shares.

The price of an ETF should be close to its NAV. Sometimes, the ETF might trade slightly above (at a premium) or below (at a discount) its NAV.

While a small difference is normal, an ETF with a much higher price than its NAV can be a warning sign. In such cases, you end up paying more than you should. So, it's important to make sure the ETF's price stays close to its NAV to avoid overpaying for your investment.

5. Expense ratio

Every ETF comes with an expense ratio, which is the annual fee the fund charges for managing the investments.

Lower expense ratios mean you're paying less in fees, and more of your money stays invested. This is important because fees, even small ones, can add up over time and reduce your overall returns. For example, if one ETF charges 0.05 per cent in fees and another charges 0.10 per cent, the difference might seem small at first, but over many years, the higher fee ETF could cost you a lot more.

So, when choosing an ETF, it's smart to pick one with the lowest possible fees that still meets your investment needs.

The last word

Choosing the right ETF is a critical decision that can impact your investment returns over time. By taking the time to evaluate the factors we've discussed—underlying index, tracking error, liquidity, price-NAV difference and expenses—you can ensure that you're making an informed choice.

Remember, there are over 230 ETFs in the market, but not all of them will align with your investment objectives. By considering these factors carefully, you can identify the ETF that best suits your needs.

An investor education and awareness initiative of Nippon India Mutual Fund.

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Suggested watch: Thematic investing with passive ETFs

This article was originally published on April 03, 2025.