Home / Money / Personal Finance /  Follow these four steps to pick the right ETF for your portfolio

Are all Exchange Traded Funds (ETFs) the same or is there a selection process that investors need to follow? Passive investing, especially ETFs, has witnessed a lot of investor interest recently. It is recommended as a low cost-low maintenance investment option for investors looking to earn market returns. The concept has gained greater visibility with many actively-managed funds trailing the indices on performance. ETF units are listed on the stock exchanges where they are traded at prices that are based on the net asset value (NAV) of the scheme. Since the costs associated with building and managing the portfolio are low as are the distribution expenses, the costs associated with an ETF are very low even compared to an index fund. Here are the steps you need to follow to make sure you have the right ETF in your portfolio.

Graphic: Santosh Sharma/Mint
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Graphic: Santosh Sharma/Mint

Identify the Index

Identify the ETF to make sure that it fits into your portfolio. Remember, all passive funds are not the same. An ETF builds a portfolio that tracks an index and this will define its features in terms of risk and return. The index can vary in terms of asset class (equity, debt, gold), sub-asset class (large-cap, mid-cap, small-cap, g-secs and liquid), and in terms of strategy, say, Bharat 22 or Nifty India Consumption Index or Nifty Value Index.

Investors should decide their asset allocation and then identify the index that gives them the best exposure to the asset class or strategy. Look a little deeper into the index to know its composition. For example, most established indices are market capitalization-based and these come with the risk of concentration. For example, in the Nifty 50 index, the top five stocks have a weightage of 41.34% and one sector—financial services—constitutes 42% of the index and the top five sectors account for 86% of the index.

Assess Tracking Error

The next step is to select the ETF that gives you the most efficient exposure to the index. Not all ETFs do it equally well. ETFs are designed to track indices. The deviation of the ETF returns from that of the index is measured by the tracking error of the fund. Higher the tracking error, greater is the deviation, which is not a positive feature. The deviation can be explained by the transaction costs that eat into its returns, the extent of cash held and the expense ratio of the fund. Have an ETF with as low a tracking error as possible.

Evaluate Liquidity

At the next level, run checks to see if you can efficiently access the ETF. This includes being able to transact in the units easily at prices that reflect the NAV of the scheme. You can buy the ETF in the new fund offer (NFO) from the mutual fund and then on the exchange, where it is listed.

The price at which the units are available on the stock exchange reflects the NAV but may trade at a higher or lower price. Buying units at a price that is higher than the NAV means that you are paying more for the stocks held in the portfolio compared to its current market value and vice versa. The ETF mechanism has a constituent, the authorized participant (AP), whose role is to manage the demand and supply of units and ensure this difference is low. If the units are trading at a higher price than the NAV, the AP infuses more units and increases the supply to bring down the prices and vice versa. But not all APs are efficient market makers.

Investors need to check how closely the price tracks the NAV and be wary of ETFs where the price and NAV consistently diverege. Buying at a price that is higher than the NAV and selling at a price lower than the NAV will mean the returns to the investor will be lower than what the underlying index actually generated. Even if there are instances of divergence, an ETF with active market makers will ensure that it is corrected soon. Price and volume data of ETFs is available from the stock exchange and the NAVs are available on the mutual fund’s website. Third-party research websites also provides the price and NAV data for ETFs. The trading volumes and bid-ask spreads are other data points available from the stock exchange to assess the liquidity available in an ETF. Many ETFs see negligible trading volumes. Gold ETFs and ETFs tracking popular indices such as the Nifty 50 see good turnover.

Similarly, the interest in ETFs linked to bank indices seem high at present. But ETFs linked to other indices are seeing low volumes. ETFs with tight bid-ask spreads, that is, the difference between the price at which investors can buy and sell units, and consistent trading volumes make it easier for investors to transact.

“The assets under management (AUM) of an ETF offers the comfort of liquidity, as well as that of experience and longevity. Sometimes a small AUM is acceptable if the ETF is from a bigger fund house. An AUM of at least 500 crore, lower expense ratio and lower tracking error are the filters that I apply," said Amit Kukreja, registered investment adviser and founder,

Periodic review

Passive investments, too, require periodic review for performance and suitability. A change in the index composition will mean a altering of the ETF portfolio too. And the change may not be something that the investor is comfortable with, either on account of the stocks or bonds included or the sector or stock concentration. Just like actively-managed funds, investors need to check the ETFs periodically for suitability and relevance. An ETF may see a change in liquidity features or tracking error and this may again be a trigger for the investor to re-evaluate the investment decision.

What you should do

As active funds find it challenging to generate alpha, low-cost passive investments such as ETFs are good long-term choices. But investors must ensure that the advantages they are seeking, like low cost, efficient transactions in asset classes of their choice, will be available to them. Investing in ETFs require a trading account and demat account and these costs add to the total cost of ownership of ETFs, along with the expense ratio. “A fund of funds (FoF) that holds ETF units in a portfolio may make greater sense from a liquidity and cost perspective. The total cost of owning an ETF needs to be compared with the expense ratio of the FoF to determine which is more efficient," said Kukreja.

The liquidity or the lack of it in an ETF impacts the efficiency with which periodic investments can be made. This is also the case when investment amounts are large. Low trading volumes and wide bid-ask spreads will affect short-term investors who looking to take advantage of market movements and are cost conscious, rather than the long-term investors. ETFs, like the Bharat Bond ETF and Gold ETFs, offer effective ways to invest in different assets, while others offer opportunities to execute specific strategies such as the Nifty 50 Value 20 Index or the Nifty 100 Equal Weight Index.

As with all investments, monitor the ETFs for suitability and performance and exit if they don’t measure up.

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