ETFs or Exchange-Traded Funds may have appeared only recently, but they have quickly found their place with increasingly more takers across different markets. In India, ETF trade has almost doubled in the span of just one year, going from INR 1.54 lakh crore at FY21 beginning to INR 2.9 lakh crore at FY21 end. These funds offer many advantages over traditional mutual funds. However, before joining the ETF bandwagon, it is important to understand ETFs and how to include them in a portfolio.
ETFs evolved as the next level in mutual funds, adding on a few more benefits. They can be viewed as passive mutual funds that track benchmark indices like Nifty. However, unlike traditional funds, ETFs are traded on the stock exchange. Where mutual funds can be traded only once a day at the close of the stock market and only by the issuing company, ETFs are traded throughout the day at the stock markets.
Types Of ETFs To Consider Investing In
ETFs have emerged as a popular investment because of their trading flexibility, greater transparency, lower costs, and tax benefits, making them an apt investment avenue in 2022. They also offer a more diverse risk exposure. But before starting, let’s find out more about the different types of ETFs.
Equity ETF
As the name suggests, equity ETFs track equities or stock indices from a particular industry. They typically mirror the performance of popular stock market benchmarks such as Nifty or Sensex. They can be further classified according to factors, market cap, and sectors.
Factor-based equity ETFs track factor-based indices that are created through active stock selection. Market cap ETFs track indices that measure performance of companies as per their market caps. Sector or thematic ETFs track an index that comprise securities from different sectors, but follow the same theme.
Liquid ETF
These are passive ETFs that track overnight rates as the benchmark. These funds invest in money market instruments or instruments with short-term maturity. Consequently, they have high liquidity with low-risk returns. They are suitable for those who want to park their money in the market for a short term, typically between investments.
Commodity ETF
These ETFs are passively managed funds that track an underlying commodity market index, such as gold or silver. Gold is one of the most popular commodities in this case as it is seen as a stable alternative in a volatile market. Gold prices are also easier to track.
Debt/Bond ETF
Debt ETFs offer the flexibility of investing in the stock market with the benefits of debt investment. These are actively traded on the NSE cash market. Debt ETFs have a lower expense ratio than mutual funds.
ETF Fund of Funds (FoFs)
FoFs track other mutual funds, investing in ETFs by different asset management companies. One can select FoFs as per the previous classifications, that is, liquid, commodity, or equity.
What to Consider When Investing in ETFs in 2022
When investing in ETFs there are some factors one must consider, such as:
Underlying Index or Asset
Like any investment, an ETF’s value comes from the underlying instrument or asset. So, the first step would be to pick the market one wishes to invest in. Next, decide on whether to invest in a benchmark index as a whole or as per a theme/sector. To ensure risk diversification, it is always advisable to go with a widely followed index that offers a good mix of options
Assets Under Management (AUM)
The AUM is calculated by multiplying the shares outstanding by the market price per share. The value of an ETF asset fluctuates as per the change in the underlying security and with creation or redemption of shares. Typically, ETFs will show a discount or premium depending on the difference between its market capitalization and the NAV (Net Asset Value) of the underlying security. A large AUM will also typically have higher liquidity.
Total Expense Ratio
Think of it as the annual management fee to be paid to the fund company to cover its expenses. It is charged as a percentage of the overall investment. So, if the expense ratio is 0.25%, the expense ratio will be INR 25 for every INR 10,000 in investment in the fund. High expense ratio adds to the cost of the portfolio and hence, it’s important to factor it in one’s calculations.
Liquidity
Since ETFs are traded throughout the day, they offer far better liquidity options than mutual funds. ETFs with high liquidity have a smaller bid-ask spread and are hence, often preferred over ETFs with lower liquidity that have a high bid-ask spread. In other words, ETFs with low liquidity will be harder to sell.
Tracking Error
It is the difference between returns on the ETF and the underlying index. It also reflects how well the ETF tracks the index. It is obviously preferable to go with ETFs with minimal tracking error.
Bottom Line
With high liquidity, risk diversification, low expenses and simple trading system, it is not surprising that ETFs have gained popularity in a very short period of time. As they pick up, ETFs will further widen their level of assets, leading to more liquidity. Not only will it benefit the investor, it can also fuel growth in the economy.
