Exchange traded funds (ETFs) have become quite popular in most countries. In India, ETFs did take off selected products due to their low cost structure. For example, in India while the Index ETFs have not taken off to the extent of index funds, we have ETFs on gold and International ETFs that are quite popular. But, how to monitor ETF?
What exactly is an ETF Investment? It is a passive investment that is benchmarked to another like the Nifty, gold price, commodity index, global indices etc. It offers a simple and low cost method of participating in markets with minimal investment. The index ETF is different from an index fund. When you go to an index fund and buy fresh units, the mutual fund actually issues new units and its AUM increases to that extent. An ETF, once its initial fund raising is completed, is a closed ended fund. You can buy an ETF in the open market only if there is a corresponding seller. The beauty of an ETF is that you can buy and sell these ETFs like any normal stock. You can trade these ETFs through your normal equity trading account and hold these ETFs in your demat account. Here are 5 things that you delve and track about your ETF.
Track the cost structure of the ETF
The reason people prefer ETF is that it is structured to be a low cost product. The only cost that you explicitly incur in an ETF is the brokerage cost when you buy or sell an ETF. Then, there is a fund manager who has to manage the fund and ensure that the fund reflects the underlying asset overall. These costs are added up and is reflected in the NAV. The market price is normally linked to the NAV. For example a gold ETF could trade I units of 1 gram of gold. If the Indian benchmark gold price is at Rs.35,000/10 grams, then the gold ETF unit will quote at around the Rs.3,500 levels.
What is the tracking error of the ETF?
This is perhaps the most important item to track in an ETF. What do we understand by tracking error? It reflects the extent to which the return on the ETF varies from the underlying asset. Tracking error is not acceptable either ways; whether it is positive or negative. The whole idea of an ETF is to passively track the underlying index or asset price. The more closely the ETF tracks the index returns, the better it is. Why is there tracking error? Typically, an ETF has costs which make the performance stray from the underlying index or asset class. Also, when index components are changed, there is a time lag between the shift in the index and the shift in the fund. That also creates the tracking error. What you need to monitor is that the tracking error is kept at the bare minimum.
Is the ETF liquid enough
Unlike a mutual fund or an index fund where you can always walk into the mutual fund office and get fresh units allotted, there is no such facility in case of ETFs. You need to only buy or sell the ETF units in the open market and hence liquidity in the market is critical. It is not only about having liquidity but this liquidity should also come with low impact costs. Otherwise, it will widen the tracking error for the ETF.
Benchmark the performance of the fund with an Index Fund
How do you benchmark the performance of an ETF? One way is to compare with the index performance. But that is what tracking error all about. Another way is to compare with a passive gold fund or a passive index fund. These funds have higher cost structured compared to ETFs. If the ETFs are still underperforming the index funds then you have a problem on hand.
Is the ETF sticking to its core objective?
The world of ETF has become extremely complicated in the last couple of decades. There are ETFs that can use derivatives to create leverage to enhance returns. Typically, the ETF is a passive source of participation in an asset class. You must not opt for a fund that strays too far from the core objective. As long as the ETF can track the underlying asset with low tracking error, that is a good enough performance. That is the core objective of the ETF, after all!