Investors must consider the equity ETF’s underlying index, asset level, trading volume, and tracking error margin
The launch of the Bharat Bond ETF (exchange traded fund) has added one more ETF option to Indian investors. Bharat Bond falls on the debt side, while there are many ETFs in the equity segment. The decision-making for the best ETF will be a subjective process. However, there will be certain key parameters on which you need to judge the relative attractiveness of the ETF; that’s the objective part. Do always remember that the process of finding the best ETF for you will differ from the process of finding the best actively managed fund. With this in mind, let us explain to you how you can go about getting your hand on the best of ETFs. Read on.
Before we begin this article, let one thing be crystal clear. Do not choose an ETF based on one factor alone such as cost, asset size, index, etc. You have to look at all the below-mentioned factors and see how the ETF fares on those. Also, we are not making recommendations here. The examples we will give are just to illustrate a point.
An ETF is an efficient way to copy a portfolio such as an index. This index is the real deal. Every index, be it Sensex, Nifty 50, Junior Nifty, Nifty Next 50, NASDAQ 100, or any thematic index, is always composed of a certain number of stocks. This index and how efficiently it is copied will ultimately decide how good or bad are your returns. To us, one of the most important things to consider about an ETF is its underlying index.
The choice of the index that the ETF will copy is very important. From the point of view of diversification, you may invest in an ETF that is based on a broad, widely followed index. But, there may be others who may want an index that has a narrow industry focus like PSU banks, consumption stocks, etc.
Take the time to look under the hood of the underlying index and see if the holdings, sector and sub-sector breakdowns make sense for you. The underlying index must match the asset allocation you have in mind.
Also, pay particular attention not just to what stocks the ETF holds, but how they’re weighted. Some indexes weight their holdings more or less equally. Others, allow a few stocks to shoulder the burden. You can check this in the individual ETF fact-sheet.
As an ETF gathers more assets under management, it becomes easier for it to cut expense ratios as costs shrink as a proportion of the revenue. For instance, SBI ETF Nifty 50 is the biggest ETF in India with over Rs 66,000 crore in assets. The ETF has an expense of 0.07%, which is quite low. We believe costs i.e. expense ratio of an ETF is ultimately a function of its size and efficiency.
Note that with bigger asset size it ‘becomes easier’ for the ETF to lower costs, but that does not mean it ‘always does’! The Rs 900-crore Kotak Nifty ETF has an expense of 0.14%, but the smaller Rs 375-crore HDFC Nifty 50 ETF has a lower expense of 0.05%
Apart from the cost angle, an ETF that you plan to buy should have a minimum level of assets. Too small an ETF is not good. An ETF with too low an asset base is likely to have a limited degree of investor interest. As with a stock, limited investor interest for an ETF translates into poor liquidity and wide spreads.
Some of the biggest ETFs in India include SBI ETF Nifty 50, SBI ETF Sensex, UTI Nifty Exchange Traded Fund, CPSE ETF, Bharat 22 ETF, Kotak Banking ETF, Nippon India ETF Bank BeES, UTI Sensex Exchange Traded Fund, and SBI ETF Nifty Bank
One of the biggest reasons for buying an exchange-traded fund is that you can exit on the exchange. Otherwise you could have just bought an index fund, where you can exit by selling the units to the fund-house. A good enough ETF should allow you to exit smoothly. So, the ETF that is being considered must have traded in sufficient volume on a daily basis.
Trading volume in the most popular ETFs will be good. On the other hand, some ETFs barely trade at all. Trading volume is a reliable indicator of liquidity. Generally speaking, the higher the trading volume for an ETF, the more liquid it is likely to be. The more liquid the ETF, the tighter the bid-ask spread will be. A tighter bid-ask spread is an important consideration when it is time for you to exit the ETF.
For instance, CPSE ETF has a two-week BSE average trading quantity of 2.58 lakh versus BHARAT 22 ETF’s 0.24 lakh. Similarly, Nippon India ETF PSU Bank BeES has a BSE two-week BSE average trading quantity of 176 only versus Kotak PSU Bank ETF’s 1047. The trading quantities are on as December 18’s 1.30 PM IST. These figures can change.
We have already discussed how it is important for you to choose the right underlying index. In this section, we will explain how important it is to have an ETF that efficiently copies an index. While most ETFs track their underlying indexes closely, some do not track them as closely as they should.
A small tracking error is justified. But, if the tracking error is bigger than peers, it is a cause for worry. An ETF with minimal tracking error is preferable to one with a greater degree of error. For example, UTI Nifty Exchange Traded Fund’s last 1-year return is 13.22% versus Nifty 50 Total Return of 13.24%. Hence, the tracking error is marginal. But Kotak Nifty ETF’s 1-year return of 13.09%, or IDFC Nifty ETF’s 1-year return of 12.91% shows that tracking error is greater.
To get a comprehensive look at tracking error, see how the ETF fares across different time periods. In the 12 Nifty tracking ETFs with a 3-year history, we found tracking error (measured in CAGR) as low as 9 basis points to as high as 27 basis points. All the returns mentioned are as on December 17, 2019.
Do note that in some cases the ETFs can deliver higher returns than the underlying index. This peculiar behaviour can happen when the ETF has generated high revenue from lending the securities.
Disclaimer: Views expressed here in this article are for general information and reading purposes only. They do not constitute any guidelines or recommendations on any course of action to be followed by the reader. The views are not meant to serve as a professional guide/investment advice / intended to be an offer or solicitation for the purchase or sale of any financial instrument including any exchange-traded fund (ETF).
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