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Business News/ Money / Personal Finance/  What should you keep in mind before investing in ETFs? MintGenie explains
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What should you keep in mind before investing in ETFs? MintGenie explains

There are certain things that investors should keep in mind before buying or selling exchange-traded funds (ETFs). Not all deserve your attention while some of them may be best dealt with after a lot of contemplation.

Check for certain factors before investing in ETFs. (Pixabay)Premium
Check for certain factors before investing in ETFs. (Pixabay)

Exchange-traded funds (ETFs) originate from investment firms that amass capital from investors and subsequently utilize those funds to invest in a diverse range of assets. These assets can encompass stocks, bonds, commodities, or alternative securities.

ETFs are actively traded on stock exchanges, akin to stocks themselves. As a result, you have the capability to purchase and sell ETFs at any point during the trading day, and their market values will oscillate based on the interplay of supply and demand.

In comparison to mutual funds, ETFs typically entail lower fees. The reason for this is that ETFs operate under a passive management strategy, negating the necessity of recruiting a team of analysts to select individual stocks. The ETFs furnish an avenue for investing in an array of assets through a single transaction. This can serve as a convenient approach to broadening the diversification of your investment portfolio.

In recent times, the appeal for ETFs has witnessed a noteworthy surge. With a selection exceeding 170 ETFs, prospective investors now have the convenient opportunity to construct an economically efficient and internationally diversified portfolio solely through the utilization of ETFs. Despite the benefits of investing in ETFs, there are some factors that investors must know before buying or selling them. These include:

Beware of the volatility of ETF prices in the open market

Purchasing or selling ETFs immediately upon the market’s opening is generally not advisable. The initial 15-30 minutes of trading can be characterized by price volatility due to limited trading volume. Consequently, you might end up paying an amount either higher or lower than you would if you waited until later in the day.

Several factors contribute to the volatility of ETF prices during the market’s opening:

Reduced trading volume: At the start of the trading day, trading volume is typically lower than later hours. The scarcity of both buyers and sellers can complicate attaining a fair price for your ETF.

Market volatility: Early trading hours often exhibit higher market volatility compared to later periods. This heightened volatility causes more pronounced fluctuations in ETF prices, potentially resulting in overpayment or underpayment if transactions are executed immediately.

Order imbalances: The market launch may involve order imbalances, where the demand for a specific ETF surpasses its supply (or vice versa). This imbalance leads to more pronounced price oscillations.

For those considering ETF transactions, it’s advisable to wait until later in the day when trading volume is higher, and the market is more stable. This approach enhances the likelihood of securing a more favourable ETF price and minimizes the risk of financial loss.

Have limit orders in place always

Employing limit orders when trading ETFs is strongly recommended. This is of particular significance when dealing with ETFs that exhibit low trading volumes, as executing market orders can result in transactions taking place at considerably higher or lower prices than anticipated.

A limit order involves specifying a particular price or a superior one at which you intend to buy or sell an asset. This implies that your order will only be carried out once the asset reaches your designated price. If the asset fails to reach your specified price, your order will not be executed at all.

On the other hand, a market order entails purchasing or selling an asset at the best currently available price. While this leads to the immediate execution of your order, it doesn't guarantee the desired price.

In the context of ETFs, market orders pose risks due to the potential for significant price fluctuations, especially during periods of heightened volatility. Opting for a market order when buying an ETF could result in paying more than intended. Similarly, utilizing a market order to sell an ETF might lead to a lower selling price than expected.

By utilizing a limit order, you can mitigate these risks and ensure that you achieve your desired price for the ETF. This holds even more importance for ETFs with limited trading volumes, as market orders might not be executed at all.

The advantages of employing limit orders when trading ETFs include:

  • Precise price control when purchasing or selling an ETF.
  • Mitigation of the possibility of overpaying or receiving less than anticipated.
  • Enhanced likelihood of order execution, especially for ETFs with low trading volumes.

Pay attention to trade during volatile markets

Exercising caution while trading in times of market volatility is crucial, given the heightened price fluctuations that ETFs can experience during such periods. This volatility may lead to unexpected outcomes, causing you to pay more or less for your ETF than initially anticipated.

Here are several guidelines to consider when trading ETFs during volatile markets:

Conduct thorough research: Before engaging in ETF transactions, ensure you conduct comprehensive research to comprehend the associated risks. This involves understanding the underlying assets of the ETF, its fees, and its liquidity.

Opt for limit orders: When purchasing ETFs, employing limit orders allows you to stipulate the maximum price you're willing to pay. This safeguards you against overpaying for the ETF.

Utilize stop-loss orders: If you're selling an ETF, stop-loss orders enable you to specify the minimum price at which you'll sell. This prevents you from selling the ETF for a lower price than intended.

Avoid trading during high volatility: Whenever feasible, steer clear of trading in periods of heightened volatility. Prices of ETFs can fluctuate significantly during such times, increasing the likelihood of financial loss.

Exercise patience: Patience is key when trading ETFs amid volatile markets. It may take some time for the market to stabilize, and immediate attainment of your desired ETF price might not occur.

Following these suggestions can aid in mitigating the risk of financial loss during ETF trading in volatile markets.

Here are a few additional considerations for trading ETFs during volatile markets:

Indicative Net Asset Value (iNAV): The iNAV is an approximation of an ETF's underlying asset value. Calculated by an authorized participant, it's typically updated every 15 seconds. Relying on iNAV can assist you in avoiding overpayment or underpayment for your ETF.

Premiums and discounts: ETFs can trade at premiums or discounts relative to their iNAV. A premium emerges when the ETF trades above its iNAV, while a discount occurs when it trades below. These variations can stem from market dynamics, supply and demand, and associated fees.

Liquidity: Liquidity reflects the ease of swiftly buying or selling an asset without affecting its price. ETFs with higher liquidity are more prone to trade at iNAV levels, while those with lower liquidity may exhibit premiums or discounts.

Trading volumes matter

The trading activity of ETFs isn't uniform across the board. Certain ETFs enjoy greater popularity and exhibit higher trading volumes, which facilitates smoother buying and selling processes and reduces the likelihood of encountering slippage—a disparity between anticipated and actual trade execution prices.

When contemplating an ETF investment, it's crucial to evaluate not only the daily trading volume but also the historical trading volumes. This assessment provides insights into the ETF's liquidity and the ease with which you can engage in buying and selling transactions.

Several factors can influence an ETF's trading volume:

ETF size: Larger ETFs typically boast higher trading volumes compared to their smaller counterparts. This is due to a larger investor base interested in trading these ETFs.

ETF popularity: More popular ETFs tend to have higher trading volumes. Increased awareness and investor interest contribute to this trend.

Underlying assets: The underlying assets of an ETF also play a role in determining its trading volume. ETFs linked to widely followed assets, like the S&P 500, often exhibit higher trading volumes than those tracking less popular assets.

Time of day: Trading volume for an ETF can fluctuate based on the time of day. Generally, ETFs experience higher trading volumes during regular trading hours when market activity is elevated.

When contemplating ETF investments, evaluating an ETF's trading volume is paramount to gauge its liquidity and ease of trading. Here are some additional suggestions for assessing ETF liquidity:

Average daily trading volume: The average daily trading volume indicates the total shares traded in an ETF over a single day. A higher average volume signifies greater liquidity.

Historical trading volume: Historical trading volume reflects the aggregate shares traded in an ETF over a specific period, such as a month or a year. A substantial historical trading volume suggests past liquidity.

Bid-Ask spread: The bid-ask spread represents the difference between the buying price (bid) and the selling price (ask) for an ETF. A narrower spread indicates higher liquidity.

By applying these considerations, you can effectively evaluate ETF liquidity and make informed decisions regarding your investments.

Invest in ETFs through SIPs

You have the ability to establish a Systematic Investment Plan (SIP) for ETFs, similar to how you would for mutual funds. An SIP involves systematically investing a fixed sum of money into an ETF at regular intervals, such as monthly or quarterly. This method offers a reliable approach to regularly investing in ETFs while implementing dollar-cost averaging.

To initiate an SIP for ETFs, the initial step involves opening a brokerage account with a broker that facilitates ETF trading. Following the account setup, you can reach out to your broker to arrange the SIP. During this process, you'll specify the chosen ETF for investment, the amount you wish to invest, and the frequency of these investments.

Facilitating automatic fund transfers to your trading account for SIPs can also be accomplished through an e-Mandate. An e-Mandate is an electronic authorization that empowers your bank to carry out routine payments to your brokerage account. This feature is advantageous as it guarantees that your SIP payments are executed punctually and completely.

Consider these advantages of employing an SIP for ETFs:

Automated investment: SIPs automate your investment activities, saving time and assisting in adhering to your investment plan.

Rupee-cost averaging: Investing through SIPs facilitates rupee-cost averaging, a strategy that mitigates investment risk.

Consistency: SIPs support consistent investment, propelling you towards your financial objectives over time.

If you're contemplating ETF investments, embracing an SIP can be an effective approach. Automating investments and leveraging dollar-cost averaging can mitigate risk and foster gradual progress towards your investment targets.

Here are additional factors to consider when establishing an SIP for ETFs:

SIP costs: The expenses associated with SIPs vary depending on the brokerage you opt for. Some brokers may levy commissions per SIP purchase, while others may not.

Minimum investment amount: The minimum investment required for an SIP is also contingent on the chosen brokerage. Minimum investment thresholds can range from Rs 500 to lower amounts, depending on the broker.

SIP frequency: You can tailor the frequency of SIP payments to your preferences, opting for monthly, quarterly, or even annual intervals.

Engaging in investments via ETFs offers a valuable avenue to leverage the stock market, enabling investors to access a diverse array of assets through a single transaction. This capability fosters diversification and risk mitigation. However, it's crucial not to embark on these endeavours thoughtlessly. Every investment opportunity, including ETFs, comes with its own set of advantages and drawbacks. Therefore, it's imperative to assess the potential risks associated with investing in ETFs before committing your funds.

 

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Benchmark index tracking ETFs.
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Benchmark index tracking ETFs.

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Published: 09 Sep 2023, 12:01 PM IST
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