Globally, when you talk of passive investing, the obvious choice is ETFs. The ETFs offer a tremendous variety in terms of asset classes that they cover. So, you can have ETFs on indices, gold, precious metals, industrial metals, bond yields, spreads etc. The list is virtually endless. ETFs are closed ended funds that are not avail on tap for regular subscription and redemption. On the other hand, they are listed on the stock exchanges with the underlying assets backing the ETF. For example, gold ETF would typically have a backing of physical gold with a gold registrar, which is normally the Bank of Nova Scotia. Same is the case for all other ETS. Let us understand how do ETFs track an index and how to track ETF performance? Here is a four point matrix as an ETF performance tracker.
Exchange Traded Funds (ETFs) are one of the best forms of investing passively in a variety of asset classes. When we say passive investing, we are referring to a situation where there are no active fund managers sitting and taking buy/sell decisions. To that extent, the expense ratio in an ETF is substantially lower compared to a normal equity fund. Over a longer period of time, this lower expense ratio adds up to quite a bit. Ideally ETFs must track the underlying asset like gold price, silver price, index value etc. Despite this relative safety that is implicit in an ETF, it is essential track four unique aspects of an ETF..
Have I zeroed in on the right index for the ETF?
This is more complex than it appears. When you buy gold ETFs, you have to choose whether you want an ETF pegged to the Indian price of gold or the dollar price of gold. The choice is critical because when you buy an ETF that is pegged to the Indian price of gold, then your gold ETF will be impacted by the international price of gold and the rupee/dollar movement. In case of index ETF, it is essential to select the index based on the theme that you choose to play on. If you want to take a passive view on the overall Indian economy then the Nifty or Sensex ETF will be the best bet. If your are taking a view on equity as an asset class, then a more broad-based index like the Nifty 500 will be the ideal underlying index for the ETF. Choice of the underlying is one of the most critical decisions when choosing an ETF.
Costs matter a lot since ETFs are a passive bet
It is a known fact that ETFs have an expense ratio lower than normal mutual funds. Even within ETFs, there are variations in cost structure, just as there are variations among mutual funds expense ratios. Prefer an ETF that has a lower expense ratio because passive investing is all about keep your costs at the bare minimum, since you are anyways supposed to underperform a portfolio of active stocks. Remember, an ETF does not require higher skill in active management and hence their transaction costs should be low and fund management fees should be much lower. When you buy an ETF, there is a transaction cost that you incur like brokerage and statutory costs. Apart from that, the total expense ratio (TER) of the ETF also impacts your NAV and indirectly your net returns.
An ETF is all about minimizing the tracking error
This measure is relevant for ETFs and index funds. So what exactly is the tracking error? As the name suggests, tracking error is the extent to which the ETF value does not track the underlying index. Even if it means that the ETF is outperforming the index with a higher tracking error, it is not a good sign. Lower the tracking error, the better the ETF is tracking the underlying. Obviously, you must prefer the ETF with a lower tracking error as your focus in an ETF is to be as close to the price of the underlying, be it gold, silver or any market index. The next question is why does tracking error arise? Firstly, there is an expense that gets debited to the fund and that distorts from the value of the underlying because index has no cost. Secondly, the underlying portfolio shifts may have a time lag and hence price changes (changes in index components) may happen during this period which will result in tracking error.
Finally, focus on size because size does matter in ETFs
Globally, the benchmark for an ETF is an AUM of at least $100 million. In the Indian context, one can take Rs.100 crore as the cut-off for selecting an ETF. Don’t jump into brand new ETFs. Wait for these funds to attain a minimum corpus of Rs.100 crore before venturing into them. Another critical aspect to focus in ETFs is the secondary market liquidity. The ETF closely tracks the price of the underlying and therefore you get returns that mirror the underlying. However, if the ETF is not liquid in the market then bid-ask spreads may be just too wide and this will distort the price that you get.
A lot of investors believe that buying an ETF is like buying a commodity. Choice of the ETF does not matter! But that is not the case!