Here are some factors to consider before choosing to invest in exchange-traded funds
Exchange-traded funds (ETFs) are passive funds that are cost-efficient as compared to actively managed funds. Investors who buy ETFs should know that the returns on these funds will resemble the underlying index.
In the past few years, ETFs have witnessed immense growth as fund houses launched several theme-based ETFs. However, if you want to invest in ETFs for higher returns, you can look at equity ETFs. But certain factors need to be taken into consideration if you are planning to invest in an exchange-traded fund.
Underlying index: Since all ETFs follow the index, investors must choose one based on their risk tolerance. As an illustration, the Nifty or Sensex ETF will track the Nifty or Sensex index, which constitutes the best companies in India. Investors can choose from a variety of ETFs, including sectoral ETFs, Next 50 ETFs, quality ETFs, and momentum ETFs. However, at Value Research, we recommend investing in pure equity funds (active or passive funds) and staying away from any thematic funds.
Tracking error: It is defined as the standard deviation of the difference between the daily total returns of the index and the net asset value (NAV) of the fund scheme. In simple terms, it is the difference between returns from the ETFs and the index. Generally, the lower the tracking error, the better the fund's performance.
Expenses: Investors select ETFs because they mirror the performance of the underlying index at a fraction of the cost compared to an active equity fund. So, if the funds' returns are similar to an index, investors should go for the cheapest ETFs among the same index.
Liquidity: This is one of the essential factors when looking at ETFs because it is important to ensure that investors can buy and sell units seamlessly. Investors should invest in ETFs that have high trading volumes, or else they will find it challenging to sell all of their ETFs at once if the trading activity is low.
Suggested read: Introduction to debt ETFs