Choosing an ETF: Best Practices

Investing in ETFs (Exchange Traded Funds) has become a popular choice in India, more than two decades after their first introduction to the market. Options in ETFs have grown exponentially in the last few years. Since the first listing of ETFs in 2002, the National Stock Exchange holds an array of 198 ETFs, offering diverse investment options to traders.  

Faced with so many options, Indian investors have to ultimately decide which one to choose.  

You need to start by categorizing the type of ETF you would prefer. Are you thinking of stocks of established companies? Are you thinking of bonds? Do you want to beat inflation with gold? If you finalize your search by category, it is easy to find the right ETFs. Even after narrowing down by categories, you still have to focus on other aspects to shorten the list further and select the best investment tool.   

Most ETFs perform by tracking indexes, trying to match listed bonds or stocks such as the BHARAT Bond ETF or the Nifty 50 Index. A tracking error shows how close are the returns of the preferred ETF compared with the benchmarks. When the tracking error value is close to zero, it shows that the ETF mirrored the index well. On the other hand, a lower tracking error indicates that the ETF generates returns close to the value offered by the index.  

You should pick an ETF with a lower tracking error while making sure the tracking quality of the ETF is consistent with time.  

Yet another way to measure tracking error is to confirm with the most recent factsheet of the ETF. A fact sheet report generally includes the ETF’s performance along with that of the index on the same chart. Ideally, the performance lines should be closely aligned throughout the history of the fund. If you notice significant periods of the ETF underperforming or outperforming the index, it implies that the ETF manager did not maintain consistency with matching the index portfolio.   

A foolproof way to ensure maximum returns is to look for products with low costs. You should consider the expense ratio of the ETF, the percentage of the investment allocated towards covering the cost of the ETF manager.  

Your objective should be to find ETFs with lower expense ratios. Since these funds are not actively managed, they generally have a lower expense ratio compared to other funds. However, the ratio varies from one fund to another. Therefore, when you compare ETFs of the same caliber, choose the one that has a lower expense ratio.   

A precondition of a good investment in ETF is to confirm if you can buy and sell it without any problem. When you are comparing ETFs, make sure to choose the ones with high trading volumes. This ensures that you can conveniently get in and out of the investment without worrying about liquidity. Also, a higher liquidity indicates a lower bid-ask spread.  

Finally, you should confirm whether the price of the ETF is close to the Net Asset Value. If the price of the ETF exceeds the NAV, it means that you are getting it expensive. 

ETFs are suitable options to diversify your portfolio. Beginner investors should seek equity ETFs, when you are interested in stocks but find it difficult. If you are looking for ETFs with good hedging value, consider gold and silver ETFs. International ETFs are also great options for diversifying the portfolio and benefit from easy exposure to overseas markets.