How to Choose an ETF?
An ETF or Exchange Traded Fund is a mutual fund that can be traded on a stock exchange like a share. It is a basket of securities that usually tracks an underlying index.
ETFs are usually passively managed funds. They are excellent diversification vehicles and cost-efficient as compared to actively managed mutual funds. If ETFs have piqued your interest, here are some tips on helping you select the right one for your portfolio. Read on!
Before we talk about how you can choose an ETF to invest in, here are some questions to consider.
What is Your Investment Plan?
Before you choose any investment instrument, it is important to create an investment plan based on factors like:
- Financial goals
- The composition of your existing investment portfolio
- The time horizon for which you want to stay invested
- Risk tolerance
These factors can help you define your profile as an investor and create an investment plan to reach your financial goals by choosing instruments that are within your risk tolerance levels.
This is important when choosing ETFs, too, since there are four categories of ETFs available – equity, gold, international, and debt.
Companies | Type | Bidding Dates | |
| Regular | Closes 18 Nov | ||
| SME | Closes 18 Nov | ||
| Regular | Opens 19 Nov | ||
| SME | Opens 21 Nov | ||
| Regular | - |
Why Do You Want to Invest in ETFs?
This is an important question, as the answer will help you choose the right ETF with ease. While some investors opt for ETFs for portfolio diversification, others choose them as an alternative to stocks. Once you know what role you want the ETF to play in your portfolio, choosing the right one can be easy.
For example, if you want to diversify your portfolio using ETFs, you can analyze your portfolio and identify sectors that you don’t have exposure to, and purchase an ETF that tracks major stocks from the said sector.
Alternatively, if your portfolio primarily has debt investments and you want to expose it to equity, then buying an ETF that tracks a popular index like Nifty 50 or BSE SENSEX makes sense. Hence, understanding why you want to invest in ETFs is important to find the right one for you. Here are some questions to help you decide:
- Are you looking for diversification alone?
- Based on your risk tolerance and current portfolio composition, are you looking at ETFs tracking equities, debt, or commodities?
- Do you want to trade the units of the ETF actively or plan to invest and hold?
- Are there any specific sectors that you want to gain exposure to?
The answers to these questions can help you understand the type of ETF that will be perfect for you. Once you have clarity on this aspect, you need to start looking for ETFs and comparing them based on the parameters mentioned below.
How to Choose an ETFs - Selection Criteria for ETFs
After determining the type of ETF that you want to purchase, it’s time to select the best ETF from the lot. Here are some factors to consider:
1. Fund Size
Should you invest in an Exchange Traded Fund with a small fund size or a large one?
While there are no rules around this, ETFs with a large fund size indicate investor interest and hence imply the possibility of higher liquidity and lower costs. Hence, avoiding ETFs with a very small fund size is usually recommended by experts.
2. Age of the ETF
ETFs have been around for nearly two decades. Every year, new ETFs are launched by fund houses to cater to the evolving needs of investors. However, with new funds, you don’t have much historical data to analyze and assess its performance.
Hence, look for funds that are at least a couple of years old if possible. However, please bear in mind that past performance is not indicative of future returns.
3. Trading Volumes
The primary differentiating factor between an ETF and a mutual fund is the fact that you can trade units of an ETF on a stock exchange. However, for that to happen, the particular ETF must be in demand.
Hence, ensure that you look at the trading volumes of the ETF before buying. Try to identify any declining trend and analyze the reasons behind it before taking the plunge.
4. Costs
Investing is about generating maximum returns at minimum risks. One of the best ways of ensuring maximum returns is looking for instruments that have minimal costs associated with buying/selling them.
Mutual funds charge an expense ratio towards administrative charges for the fund. Since an ETF is passively managed, its expense ratio is lower than an actively managed fund. However, two similar ETFs can have different expense ratios as decided by the fund house.
Hence, if you are comparing two ETFs of the same calibre, then you can consider the one with a lower expense ratio since buying/selling units on a stock exchange will also incur costs.
5. Tracking Error
If the ETF you are invested in is tracking a specific index, then the fund manager will try to buy securities in a manner that the returns of the fund are similar to those offered by the underlying index. However, since the fund manager does not purchase all securities that make up the index, there is a possibility of a difference between the returns offered by the ETF and the Index.
This is the tracking error. A lower tracking error implies that the ETF has generated returns closer to that offered by the index.
Hence, prefer ETFs with lower tracking errors.
Summing Up
Remember, creating an effective investment portfolio requires you to pay attention to a lot of factors. Hence, before you choose an ETF to invest in, ensure that you are in sync with your existing investments and that the ETF can help boost the overall returns of the portfolio.
An Exchange Traded Fund is a powerful investment vehicle. Use it right and achieve your financial goals with ease.
Happy Investing!