Investing in mutual funds is easy today. All you need is a savings account and become KYC (Know Your Customer) compliant and you can start investing in mutual funds either directly through the AMC’s website or through your bank’s online mobile banking app or any of the other platforms made available by the third party aggregator or the mutual fund broker. An alternative to mutual funds is exchange traded funds. Both mutual funds and exchange traded funds share a lot of common traits yet there are a few factors that distinguish these two. Let us find out more about exchange traded funds and some of the parameters which investors might be aware of before investing in these funds.
What are exchange traded funds?
An exchange traded fund, or ETF as it is commonly referred to as is an open ended mutual fund scheme whose units are available for trading at their current live market price throughout the trading hours just like company stocks. These are the only type of mutual funds that are publicly listed at almost every stock exchange and try to generate returns by replicating the performance of their underlying index or benchmark with minimum tracking error.
Parameter to look at before investing in ETFs
The benchmark of the ETF
While ETFs may invest in a diversified portfolio of stocks, they usually only invest in stocks that comprise a specific benchmark or index. Hence, as investors, it is essential for us to first understand that market in which we want to explore investment opportunities and accordingly invest in the ETF. Index ETFs or ETFs with benchmark invest in stocks belonging to a particular index but sectoral / thematic index invest in companies of a particular theme or sector.
Total Expense Ratio (TER) of the ETF
An expense ratio comprises fund manager fees, operational costs, etc. that must be taken care of by the AMC to ensure that the fund is functioning properly. These expenses are adjusted from the investor’s overall gains in the form of an expense ratio. This is why investors must consider investing in an ETF that has a feasible expense ratio. A scheme with a high expense ratio can eat up a lot of your capital gains in the long run. Since ETFs are passively managed, they usually carry a low expense ratio. An expense ratio of.15 percent means that the ETF uses .15 percent of the fund’s total assets to manage its expenses.
Tracking error and ETFs
Since these are passive funds, ETFs are designed to replicate the performance of their underlying index with minimum tracking error. Unlike other active funds that try to outperform their benchmark, ETFs try to track their performance instead of outperforming. While closely tracking its underlying benchmark index funds have to ensure that they minimize the tracking error. Investors must consider ETFs that have a low tracking error record.
ETFs are highly liquid in nature
While the expense ratio and tracking error are important factors to take into consideration while choosing an ETF, the liquidity of the is scheme is equally important. Since ETFs can be traded at the stock exchange like company stocks, they are known to offer high liquidity. ETFs with low liquidity have higher concentration risk whereas ETFs with high liquidity have risk spread across the portfolio.
ETFs are highly volatile in nature and thus investors must ensure that their risk appetite allows them to invest in these funds. Depending on their investment objective one can either indulge in intraday trading or consider ETFs for the long term.