Selecting an ETF or Index Fund

Many asset management companies (AMCs) have launched exchange-traded funds (ETFs) in recent times. There are also quite a few which have been filed and are pending approval at Securities and Exchange Board of India’s (SEBI) end. Not only ETFs but also index funds have seen a lot of traction. Edelweiss’ recent launch of the first debt ETF in India shows the emergence of passive investing in India.

The main question that arises in this situation is how to select an ETF to invest in. The factors listed below help in making this decision.

1. Lower tracking error

Tracking error is one of the most important attributes for measuring the performance of an ETF or Index Fund as against their own benchmark. It is simply the difference in returns between the ETF and its benchmark. Lower the tracking error, closer is the returns of an ETF or index fund with those of its benchmark.

2. Low impact cost

Impact cost is an indirect cost of executing a transaction on an exchange. Lower the impact cost, lesser the indirect cost to investors. Impact costs are lower where the liquidity is higher.

To understand this better, let us imagine a scenario where you want to purchase 5,000 units of ETF on BSE. Suppose, the best-buy order of 1,000 ETF units is Rs 580 and best-sell order for 2,000 ETF units is at Rs 582. Thus, the ideal price is the average of both, i.e. Rs 581.

We note that it is not necessary that we get the price we are looking for. Different sellers will quote at different prices for different quantities. Thus, the average of actual available prices will differ from our expected price. This difference marks the impact cost of a transaction and will not be more than 1 per cent. It is to be noted that a market with high existing liquidity will offer more flexibility with prices, thereby, increasing the chances of making our transaction as close as possible to our expected price. Therefore, higher the liquidity, lower is the impact cost.

3. Low Expense Ratio

Expense ratio refers to the annual charges of an ETF. It is the sum of fund expenses, management fees, operating costs, administrative fees and all other asset-based costs that are incurred. However, expense ratio must not be looked at and considered in isolation.

4. Historical Records and Liquidity

See the historical records and liquidity of any ETF is crucial. Although historical records do not show future performance, they give an indication based on how it has performed in the past. Also, liquidity of the underlying stocks should be checked and not of the actual ETF.