Raman, a Generation X corporate employee who was into stock markets for over 12 years, was unaware about Exchange Traded Funds. On a get together with his school friends, he was introduced to the investment instrument. Many of his friends, including his best friend Aisha, were into investing in ETFs and recommended him to try it. Giving in to their suggestions, he searched online and referred to one of the top asset management companies’ guide on investing in ETFs for beginners.

What are ETF funds?

ETFs pool in funds from various investors, are managed by a fund manager and have an NAV (Net Asset Value) like mutual funds. However, there are 2 striking features that make this option different from mutual funds.

• Just like shares and stocks, an ETF can be traded on the stock exchange.
• It is managed passively and generally tracks an index. Note that, today in India, ETFs are one of the popular investment avenues for passive investing.

As mentioned previously, ETFs are listed on the stock exchange where investors can trade them just like stocks. However, their price per unit is not determined as per NAV but according to the market’s demand and supply. All investors looking to invest in ETFs are required to open a trading and a demat account to be able to trade ETFs.

With this brief, Raman was clear about the concept of ETFs and wanted to know about this instrument’s history with some stats regarding its acceptance in India. As the ETF guide that he had found did not cover this portion, he looked up online to find some other trusted source for information. After a browsing the internet for quite some time, he was able to find a reliable source.

 A brief background and stats concerning ETF

Benchmark Mutual Fund were pioneers to launch ETFs in India. The country witnessed its first ETF in 2002 – the Nifty Benchmark Exchange Traded Scheme or Nifty BeES. This got listed on NSE and tracked Nifty 50 Index.  Since then until the year 2015, the growth of ETFs has been extremely slow. However, in the past 5 years, ETFs have received huge traction as the AUM surged from about Rs. 25,000 crore in July 2016 to more than Rs. 3.30 lakh crore in July 2021, which means ETF AUM has increased at an annual rate of 68%. The increasing interest among investors could be attributed to the well diversified and low-cost nature of ETFs.

Raman again went back to the guide on ETFs for beginners to dive into different ETF categories.

• Equity ETFs: They track the movement of stock indices or cluster of stocks from a specific industry or section. Basic idea here is to replicate the performance of a sector or index by investing in stocks. 
• Gold ETFs: Opting for gold investing is a good hedge against currency fluctuation as well as economic downturns. However, opting for investment in physical gold comes with numerous concerns such as quality, security, making charges, etc. As gold ETFs are backed by physical gold of the purest form, these allow investors to become owners of gold with no burden attached regarding asset protection.  
• International ETFs: There are a few ETFs that track stock indices of international markets and enable their investors to get exposure to such international markets as well as participate in growth stories of specific companies. 
• Debt ETFs: Such ETFs invest in fixed income securities like debentures, government bonds, etc.     

After being clear about ETF types, Raman was anxious to invest in them and quickly moved on to the last part of the ETF guide – crucial factors to consider when selecting an ETF.    

What are the checkpoints to clear to choose the correct ETF?

ETFs’ category: As stated above, ETFs are categorized into 4 types – equity, debt, international and gold. Once you decide on the category as per your risk appetite, you need to look at their subcategories. For instance, those wanting to opt for equity ETFs need to choose one from factor based, market based or sector/thematic based funds.

ETFs’ trading volume: Since ETFs’ introduction in India in the year 2002, ETFs’ trading volumes have spiked. However, there still are a few ETFs that have lower trading volume than the rest. Thus, those looking for both liquidity and good unit price should select ETFs with a high trading volume.

Expense ratio: ETFs’ expense ratio is lower as compared to those of actively managed mutual funds. Also, there are many fund houses that provide further discounts on their expense ratio to get more retail investors. Note that having a lower expense ratio equates to having a better chance of availing good returns.

Reduced tracking error: ETFs generally are formed to track indices. They invest in securities that mimic the performance of an index. While there is some difference between that index and ETF returns, it is certainly not poles apart. A tracking error is taken up to measure the difference in ETF performance in respect to the underlying index. In an ETF, if the tracking error is lower, it holds a greater chance to be closer to the index. Hence, one should look for a low tracking error ETF.

This ETF guide proved to be helpful for Raman as he was drawn towards the investment instrument and found it to be a prudent investment option due to its cost effective, liquid, and diverse nature.

Gauging if ETFs are for you

Always remember that the hallmark of being a successful investor is to know all the available investment options and work on a financial plan based on financial goals, investment horizon and risk appetite. Before beginning with ETF investment, ensure you have in place a proper investment plan and complete understanding about the intricacies of ETFs. As they are managed passively, they are formed to match the returns that are offered by an index and certainly not overcome them.

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