Investing in ETFs: Ensure low tracking error, alignment with risk appetite

Exchange-traded funds (ETFs) witnessed a sharp rise in subscriptions in October, with net investments totalling Rs 13,441 crore, compared to Rs 381 crore in the previous month, according to data from the Associa­tion of Mutual Funds in India (Amfi). While most of the inflows into ETFs have traditionally come from institutional investors such as the Employees’ Provident Fund Organisation (EPFO), they are also gaining traction among retail investors.

  “While some flows can be attributed to a few large provident, pension and institutional funds, we are witnessing wider participation from all types of investors. ETFs account for roughly 17 per cent of the total assets under management (AUM) of the mutual fund industry with over 2.35 crore investor folios,” says Arun Sundaresan, head ETF, Nippon India Mutual Fund.

 

  Exposure to array of indices

  ETFs, which are listed on the exchanges, nowadays offer exposure to an array of indices. “Passive funds provide investors with a wide array of niche and unique investment options, ranging from a portfolio tracking a market segment like the Next 50, a theme like manufacturing or electric vehicles (EV), a strategy like low volatility or momentum, an asset class like silver, or a specific country or group of countries,” says Siddharth Srivastava, head-ETF product and fund manager, Mirae Asset Investment Managers (India).

  ETFs also stand out for their affordability, with expense rat­ios significantly lower than tho­se of actively managed funds. “A big advantage of investing in ETFs is low cost. For example, Nifty 50 ETFs are available at just around 0.05 per cent expense ratio,” says Srivastava. 

ETFs are straightforward investment products that mimic the performance of specific indices. “They allow investors to get returns close to their chosen underlying index. There is no risk of the fund underperforming the index, except by the low expenses of the fund and minor operating costs,” says Sundaresan.

  Additionally, ETFs allow investors to buy and sell during trading hours. “ETFs provide the option to take advantage of intraday market movements, unlike traditional mutual funds,” says Sundaresan. 

Open demat account, pay brokerage

  To invest via ETFs, however, investors must have a demat account and incur transaction charges. “One needs a demat account, and there are associated broking charges in ETFs. It is also difficult to do systematic investment plans (SIPs) and systematic withdrawal plans (SWPs) in them,” says Parul Maheshwari, certified financial planner.

  Selecting the right ETF

  Here are four criteria investors must take into consideration when selecting an ETF: 

- Expense ratio: A lower expense ratio generally translates into better returns for investors.

  - Tracking error: It measures how closely the ETF follows its underlying index. A lower tracking error results in better performance.

  - Trading price vs NAV: Check the price on the exchange against the fund’s NAV (Net Asset Value) to avoid paying a significant premium or selling at a significant discount.

  - AUM: A larger AUM ensures the fund managers devote adequate attention. It also results in better liquidity, so investors can buy the ETF at a price close to the NAV.  

  “Keep in mind the size of the fund and liquidity and invest according to your asset allocation,” says Maheshwari.

  Avoid trading 

Investors should approach ETFs as long-term investments and avoid frequent trading. “The ideal holding period should be more than five years in equity ETFs,” says Maheshwari.

 

Srivastava suggests combining ETFs with actively managed funds to create a robust portfolio. “Passive funds can be 40–60 per cent of an investor’s portfolio,” he says.