There are many investment options before the investors in the current era. One of these options is that of Exchange Traded Funds (ETFs) which invest the investors’ capital in a set of several stocks. This includes everything from traditional stocks and bonds to modern securities like currencies and commodities. Any investor can buy and sell his shares of the ETF through the broker. Its business is done in the stock market.
ETFs are rapidly gaining popularity due to their low expense ratio (as low as 0.06 per cent), better tax efficiency than active funds, diversification benefits and index linked returns. However, according to Luv Chaturvedi, CEO, Reliance Securities, just like it is necessary to investigate before investing in a stock, similarly some aspects must be done before investing in ETFs.
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Before investing, check the ETF on these parameters
- ETFs should cover all asset classes rather than just equities.
- While choosing or investing in an ETF, investors should rely on the L4U strategy – liquidity, low expense ratio, low impact cost, low tracking error and underlying securities.
- The liquidity of the ETF will make it easier for investors to buy or sell it on the stock exchange. Liquidity means that the ETF should have sufficient trading volume on the exchanges.
- Generally, the expense ratios of ETFs are lower than that of active funds but investors must compare the expense ratios of various ETFs among themselves as it affects the overall returns.
- Impact cost is the indirect cost of a transaction on the exchange. The higher the liquidity, the lower the impact cost and thus the investors will have to pay less indirect tax.
- Low tracking error is an important factor while choosing any ETF. This helps in reducing the difference in returns compared to the index. Generally, a tracking error of 0-2 per cent is considered ideal for the underlying securities.
- The most important parameter while choosing an ETF is the underlying securities as the returns depend on its performance.
Investors’ interest in ETF has increased rapidly in India
The trend of investors towards ETFs is increasing all over the world. This can be gauged from the fact that over the last ten years, ETF AUM across the world has grown at a compound annual growth rate (CAGR) of 19 per cent. In 2020, it has crossed the level of $ 7.7 lakh crore (Rs 562 lakh crore). In India, the ETF AUM has grown at a CAGR of 65 per cent in the last five years and the share of ETFs in the total AUM (Asset Under Management) increased from 2 per cent in FY16 to 10 per cent in FY2121. Interestingly, 90 per cent of the investment in ETFs is from institutional investors (mainly EPFO).