Questions You Need to Ask Before Investing in ETFs

Investing in Exchange Traded Funds is similar to buying shares of an Index. As an investor, you either bid for the shares or buy them at the market price as shares of these funds are listed on the stock exchanges. 

Each share you purchase results in holding a part of all the shares in the index with the same weights as in the Index composition. It is a simple, familiar process but the investors and spectators of the market are recommended to undertake their due diligence and research before investing. 

This article lists a few important questions and factors that an investor should consider before adding ETFs in their portfolios- 

What are your Investment Goals?

The first and foremost thing to define is what are your goals for investing. Do you want to invest to buy a house or to sponsor your children’s education? It can be any tangible goal you can define. Knowing your investing goals helps you choose the right ETF amongst the listed funds. This helps the investors know their risk-taking capacity and return objectives. While investing for retirement will require a low-risk constant return ETF, investing in purchasing an expensive car will result in choosing a high return-high risk fund. Investment advisors like Tavaga can help you plan your goals in the way that suits you. 

Defined Investing goals also help you know how much money you need to put aside every month or year and at what rate of return so that you can achieve your goals in the desired amount of time. Suppose you have additional savings of Rs. 30000 a month that you want to invest to buy a car worth Rs. 75 lacs in the future. For this goal, you will have to invest Rs. 30000 every month at an annualized return of 13% for the next 13 years for your investment corpus to be Rs. 75 lacs. Not knowing your goal will lead you to not know your return objectives and holding period, which further leads to poor financial planning. Tracking the performance of your investment also becomes easier when you have a set objective in mind. 

Investment returns of select ETFs vs Mutual Funds:

How are ETFs different from other investment instruments like Mutual Funds and Stocks?

While an ETF is a type of mutual fund which is passively managed, general Mutual Funds are actively managed by portfolio managers. Passive management means that they track the index and replicate the index results while active managers try to beat the index by changing the weights of the stocks and timing their investments.

Mutual Funds also attract a higher expense ratio because of the active management as compared to the low expense ratio that ETFs charge. The performance of ETFs does not depend on the fund manager but on the overall market and the condition of the economy. 

ETFs are much like stocks because both can be traded on an exchange using a Demat account. Both attract brokerage and related costs and can be bought or sold at any time on the index. Because of being listed on the exchange, stocks and ETFs enjoy high liquidity. But, stocks carry their own risk along with the market-wide risk while ETFs diversify the portfolio and eliminate the stock-specific risks. 

What is an underlying index?

ETFs track the return of an underlying index. An underlying index could be any index listed on the stock exchanges around the world like Nifty 50 or Nasdaq 100 etc. The ETFs hold shares in the exact weights as the underlying index. An ETF based on the S&P 500 index will replicate the performance of the index. Since the fund holds 500 shares of various industries, the company-specific risks are almost eliminated and investors bear the market-wise systematic risks and returns. In the long run, as these big companies continue to grow, the index value increases and provides positive returns to the investors of the ETF.

What are the costs, commissions, and fees associated with ETFs?

ETFs, carry with them certain costs and fees which affect the funds’ returns. An investor should incorporate these costs while calculating their desired rate of return. The major costs associated with ETFs are:

Expense Ratios 

The net expense ratio includes waivers, reimbursements, and trading costs, whereas the Gross expense ratio is equal to the percentage of total mutual fund assets used to run the fund.

The expense ratio is a measure of the annual fund operating expenses of an investment fund. It is expressed as a percentage of the fund’s assets under management (AUM). The fund’s operating expenses include spends on administration, management, and advertising

The expense ratios for ETFs range from 0.1% to 0.7% per annum which includes all the fees the fund house is charging.

Brokerage, STT, and Other Charges

Your broker also charges certain fees for its services, called brokerage charges. The average brokerage charge on purchasing ETFs is 0.01% of the turnover value. Apart from that, STT stands for Securities Transactions Tax and is a fee levied by SEBI. It stands at 0.01% of your turnover value. Demat Transaction charges (DTC) charges range from Rs. 15-40 depending on your broker and his Depository Participant. 18% GST is also charged by the Government of India on brokerage + transaction charges. 

Overall, the net charges stand close to 0.5-1.0% of your total Assets Under Management (AUM). To know about the costs in detail, visit our blog: Costs, Commissions, and Fees Associated with ETFs.

What are the general risks associated with ETFs?

ETFs are designed to create well-diversified, low-cost portfolios, and therefore eliminate asset-specific risks. Fund houses purchase negatively correlated assets to offset an adverse movement in one asset by a favorable movement in another. ETFs also provide access to otherwise inaccessible markets and thinly traded assets. However, ETFs sustain exposure to systematic risk, which cannot be diversified away.

ETFs, contribute to end-of-day volatility as the fund managers have to rebalance the weights of securities in the fund to match that of the tracking index. Such trading distorts information-based trading. ETFs face rebalancing risks for illiquid and inaccessible markets. 

Conclusion

ETFs have stirred the Indian markets by being a relatively new investment vehicle. In more developed economies like the US, ETFs comprise a large share of the market. Provided the low investment costs, diversified portfolio, and good returns, ETFs do turn out to be an attractive fund to invest in. Based on your goals, you can pick the best ETF suited to your risk aversion and return requirement. But investors should always incorporate the additional costs while calculating their investment returns from ETFs. Investors can also talk to their investment advisors to understand the product in a better way. ETFs have beaten mutual funds in recent years and are gaining traction in the Indian markets.