As an Indian investor, the concept of investing in overseas equities has started gaining prominence only recently. Until then, investing overseas was confined only to a few large fund houses. For Indians, investing would mean allocating their funds to stocks, real estate, gold and mutual funds. Very few have had the awareness and the willingness to invest in ETFs or Exchange Traded Funds.

Traditionally, the most popular route to invest in is through mutual funds. A mutual fund is a professionally managed investment fund that pools money from investors and the proceeds are used to buy stocks or bonds. Mutual Funds are run by Asset Management Companies (AMC). The goal of the manager is to outperform the benchmark.

WHAT ARE ETFs?

An alternative to mutual funds are ETFs. For those unaware, an Exchange Traded Fund (ETF) is a type of investment fund which trades on the stock exchanges. An ETF can be bought or sold throughout the day as the price keeps changing, similar to stocks. ETFs track an index, and the goal is to perform as close to the index as possible.

HOW DOES ETF DIFFER FROM MUTUAL FUND?

The biggest difference is that an ETF has no active fund manager, unlike a mutual fund. On the other hand, different schemes of a Mutual Fund have different fund managers. Some may also have specific lock-in periods, which means you cannot sell your mutual funds without paying a fixed fee before it expires.

An ETF tracks a particular index. The index can be a benchmark or belong to a specific sector or asset class. Yes, crude, gold, metals, all have their respective ETFs. Benchmark indices have their respective ETFs too. For example, as of date, there are 19 different ETFs that track the US benchmark, the S&P 500.

Another factor that differentiates a mutual fund from an ETF is cost. Most ETFs tend to have a lower cost than the corresponding MFs. This is because ETFs don’t need to pay expensive active management fees and are focused on mirroring the underlying indices.
By investing in ETFs, you can focus on the theme in its entirety instead of having to go through the trouble of sifting through the multiple stocks that the sector is composed of. Moreover, a sectoral ETF does not involve an exit load as mentioned above, and you can take short-term positions in sectors through the ETF.

THINGS TO CONSIDER WHILE INVESTING IN ETFs

Underlying Index: While investing in an index ETF, you need to first decide on the market you wish to invest in. Once you decide that, you either determine whether you wish to invest in the benchmark index as a whole or a specific sectoral index. A benchmark ETF would generally buy all the stocks that are part of the index, but a thematic or sectoral ETF would focus only on the stocks in that particular sector.

Total Expense Ratio (TER): An expense ratio is an annual fee a fund charges to cover its expenses. For example, if an ETF has an expense ratio of 0.20%, it means the fund uses 0.20% of the assets to cover the expenses. Different funds tracking the same index can have different expense ratios.

Tracking Error: ETFs must closely track the benchmark. Traditionally, tracking error is defined as the standard deviation of the difference in returns between the ETF and the index. An ETF with lower tracking error to its benchmark should be preferred to others.

Liquidity: One of the most crucial factors of an ETF. When considering ETFs, other than TER and Tracking Error, liquidity is also very important. As ETFs are traded intraday on an exchange, those ETFs with greater liquidity can be expected to have a lower bid-ask spread, while low liquidity ETFs shall have wider spreads. Thus, one should prefer ETFs with greater liquidity.

AUM: AUMs or Assets Under Management of an ETF is calculated by multiplying the shares outstanding by the market price per share. The AUM of an ETF is subject to change based on the changing value of the underlying security as well as the creation of new shares or redemptions of the existing ones. ETFs with greater AUM tend to have more liquidity. Thus, one can use AUM as a proxy for liquidity.