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How to choose an ETF

Key parameters to consider before you invest in an ETF

How to choose an ETF

As we saw in the previous article of this series, an ETF, or exchange-traded fund, is a rather simple product which just tracks an index. So, by investing in an ETF, you are effectively investing in its underlying index. Your returns will also likely be index-like. For instance, if you invested in a Sensex or a Nifty ETF, you would get similar returns as those from these indices.

A look at your available ETF options reveals that there are 26 ETFs tracking the Sensex or Nifty indices. You may ask, what's the difference between them? If all of them track the same index, shouldn't you just pick one randomly? Well, not really, because there are differences even among the ETFs that track the same index. Here are the various parameters that you should keep in mind while picking an ETF.

Underlying index: An ETF tracks an index, so first decide which index you would like to invest in. Sensex and Nifty comprise large-cap stocks. So, by investing in ETFs that track them, you are investing in large caps. There are ETFs tracking mid and small caps as well. Then there are those that track international indices. The chart 'Break-up of the available ETFs' shows the number of ETFs in terms of their underlying.

As one can see, the ETF universe is highly skewed towards ETFs tracking large-cap indices, such as the Nifty and the Sensex. This is because of the ease of replicability. Large-cap indices constitute most liquid stocks and hence it's easy for the fund manager to mimic them. On the contrary, ETFs tracking mid and small caps have to struggle harder to replicate their underlying, given that these segments tend to be less liquid.

Liquidity: While investing in an ETF, it is important to ensure that you can buy and sell its units with ease. Thus, it is important to choose an ETF that trades with a fairly high trading volume. This is similar to investing in a liquid or an illiquid stock. A liquid stock provides you a smooth buying and selling experience. But with an illiquid stock, your order may remain unexecuted for a long time.

How to choose an ETF Entities called authorised participants (APs) play an important role in maintaining the liquidity of ETFs. An AP is a large financial institution, such as an investment bank, that purchases or sells shares required to create a unit of ETF based on the market demand. When the demand of ETFs is high, the AP purchases more stocks and helps create more units of the ETF. Similarly, when the demand of the ETF is low, the AP removes ETF units from the market.

Difference between the price and NAV: The price of an ETF should move in tandem with its net asset value (NAV). Since an ETF is a mutual fund that trades, the NAV is the actual price of its unit. If the price is more than the NAV, you are actually getting the ETF expensive. The vice versa is also true. So, a good ETF will reflect an orderly movement of its price and NAV. On occasion, however, due to supply-demand dynamics, this sync may get disturbed. Hence, always see the price-NAV difference at the time of investing in an ETF.

Tracking error: The tracking error indicates how well an ETF tracks its underlying index. The lower the error, the better.

Expenses: While choosing a fund, expenses are an important consideration. In the case of actively managed funds, an investor may give preference to performance over expenses but in the case of ETFs, where the returns are almost certain to be like the underlying index, it would make sense to go for the cheapest ETF. For two ETFs that track the same index, go for the cheaper one, provided that the rest of the determinants are the same.

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