scorecardresearchHow to select the right ETF? A key guide

How to select the right ETF? A key guide

Updated: 21 Apr 2022, 07:53 PM IST

Invest in an ETF that boasts of high trading volumes, more liquidity, low expense ratio and the lowest margin of tracking error.

Investing in ETFs 

Investing in ETFs 

Exchange-traded funds (ETFs) are mostly like mutual funds in the sense that they also pool the money of inclined investors to create a portfolio of shares and stocks with a futuristic outlook. However, unlike mutual funds that can be redeemed and the earnings whisked away, ETFs are traded on the stock exchanges. This means that ETFs must be bought and sold like stocks instead of relying on a fund management company to invest in mutual funds. This explains why you must not look beyond just returns and expense ratios before putting your money in ETFs.

Both mutual funds and ETFs can do wonders to your portfolio considering how they both offer instant diversification at a low cost. However, as opposed to the former wherein fund managers constantly allocate and reshuffle stocks ETFs are more passive since their returns mirror their portfolio index. More investors have shown interest in parking money in ETFs owing to their comparatively low costs that stem from their passive nature. The details shared by the Association of Mutual Fund in India (AMFI) highlight how 12,384.09 crores got invested in ETFs in March alone.

Kind of fundAssets under Management (in crores)
Passive Open-ended funds1375224.70
Passive Closed-ended funds8272.90
Exchange-traded funds349329.63
Index funds39639.07
Fund of Funds30621.82

Data of Assets under Management as on March 31, 2022

Source: Value Research

Choosing the right ETF

We spend so much time earning money and deciding how much of it must be spent and invested. Why not utilize the same time in researching ETFs before deciding which of them is worth investing in?

To start with, check for the ETFs with exceptionally trading volumes and those that offer enough scope for liquidity. This is because if you are looking to sell your ETF in future, there must be someone at the other end of the terminal showing both willingness and readiness to buy. It is then you must take the next step of looking at their expense ratios and their tracking errors.

For the unversed, tracking error is similar to the concept of standard deviation used in statistics. Simply look at the portfolio returns of the ETF in a particular year and compare the same with the benchmark index return. Though tracking errors are not supposed to be more than two per cent every year, you must check which ETF has the lowest tracking error and choose the one accordingly. Since ETFs mirror index returns, it is no surprise that their returns must also be close to the benchmark returns.

Though the ETF returns mirror the index returns, there is always a scope of tracking error as the fund manager may not be inclined to invest in all the stocks that make up the index. With some stocks outperforming the others while erosion in the prices of some mitigating the overall returns’ effect, some ETFs have a higher value of tracking error than others.

You can view some of the best ETFs along with three-year returns and expense ratios in the following table.

Name of the ETFThree-year Returns (in %)

Expense Ratio (in %)

Motilal Oswal NASDAQ 100 ETF380.57
HDFC Sensex ETF22.060.05
SBI-ETF Sensex19.750.07
UTI Sensex ETF19.770.07

ETF selection process

Investing in ETFs offers you the same exposure to diverse instruments like equity, debt, commodities and global equities. You must select as per your risk aptitude. Millennials showing risk propensity choose ETFs mirroring equity indices to gain from the market movement. Now that you have zeroed in on the asset class, for example, equity must now identify the index. Some investors opt for large-cap indices such as Nifty or Sensex or sectoral indices such as banking or technology or any other within the equity space.

Let’s take a look at the difference between ETFs vs. Stocks vs. Mutual Funds.

A lot depends on the fund manager’s ability too. There is a famous adage that says, “A lion can lead a flock of sheep, but never expect to win a battle with a lamb managing a group of lions.” Management quality matters and that is what you look for while assessing the quality of a fund manager. Check how other funds’ returns are managed by these managers to gauge how active they are in the market.

Look for volumes and liquidity

An ETF with a high volume is as good as it gets. So look for ETFs with exceptionally high volumes. If you scan through the data of Nifty50 ETFs, you will find NiftyBees trading at an exceptionally high volume of 16,12,294 units in the market while QUANTUM NIFTY 50 ETF trades with as low as 111 units in the market.

Retail investors must also look at an ETF’s liquidity levels before considering it. Not all retail investors make high volume transactions, which means that those small investments can face liquidity issues while investing in ETFs with low trading volumes. The investors then have to sell at a much lower price than that offered by other ETFs, which means that their returns do not match the index.

Kiran Telang, Certified Financial Planner and author of “Mindful Retirement” & “Moneywise-Perspectives for Women” says, “Investments are normally done with a certain goal in mind. The proceeds from that particular investment should be ideally available when the goal arrives. If a particular investment option has low liquidity, the investor will have to look at alternate options for funding his or her goal if the liquidity dries up during his or her time of need.”

The ETF market is still new to many retail investors though many institutional investors are known to park large sums in it. The lower liquidity in some ETFs is a cause of concern for many retail investors as they have to pay high transaction costs owing to low liquidity and are therefore not able to sell at a fair price. This means that investors do not have access to the amount of money they are looking for as and when they need it the most. The investment goal bites the dust as the feeling of notional loss eats into their financial planning.

Tax implications

Did you know that the definition of long-term capital gains varies across ETFs when it comes to calculating taxes on the earnings? For example, the tax structure applied to equity ETFs is different from that applicable to gold ETFs.

Viral Bhatt, Founder and Owner of Money Mantra says, “Index ETFs and sectoral ETFs are treated as equity-oriented schemes for the purpose of taxation. Accordingly, short term capital gains made on ETF units held for less than one year will be taxed at 15%. Long term capital gains on units held for more than one year will be taxed at 10%, without indexation benefit. Long term capital gains up to 1 lakh are not taxed.”

However, the same rules do not apply to others including gold ETFs and international ETFs. Bhatt says, “For taxation purposes, gold ETFs and international ETFs are taxed as non-equity funds. Short term gains made on ETF units held for a period of fewer than 36 months are taxed as per the applicable income tax slab rate. Long term capital gains on units held for over one year are taxed at 20% after indexation benefit.”

Opting for an ETF

Though there may be no exceptional tax benefits in investing in ETFs, the tax liabilities in mutual fundsare comparatively a notch higher, thus, causing more people to now shift their focus to ETFs as evident from the increasing number of investments in them. Now more people are investing in ETFs with the total value of ETF transactions estimated to be 3,72,97,73,619.03 crores in March 2022 alone. However, the understanding surrounding ETFs continues to be low, thus, causing many people to park their money in ETFs trading at low volumes with lower liquidity levels and higher expense ratios. The concept of “tracking error” is unknown to most people, which means that they do not care to check if the portfolio returns match the benchmark returns and how close a certain ETF’s returns are to the index returns.

First Published: 21 Apr 2022, 08:02 AM IST