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Tips to choose the right ETFs

By Meenakshi Subramaniam in Mumbai
August 25, 2009 10:31 IST
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There are a number of things to check to avoid losses, says Meenakshi Subramaniam.

It's a close cousin of the mutual fund. Nevertheless, it provides the thrill of stocks, too.
The exchange traded fund (ETF), the most exciting investment in the market, is capable of giving sweeping returns.

There are three types of ETFs, namely index exchange traded funds, commodity ETFs and bond ETFs. Index funds hold securities and replicate the stock market index. Whereas one company share may cost Rs 21,725 in the stock exchange, an index fund may allow you to buy one share for Rs 285.70, investing in 50 companies.

Among commodity exchange traded funds, there are gold ETFs, whose scintillating presence is familiar to all. In the bond category, there's liquid ETF, which invests in money market instruments.

There are more than 100 index-based ETFs, six gold ETFs and one liquid exchange traded fund. How should one choose the right ETF, among these myriad options?

Here are ways to pick the right ETF:

Choose single portfolio

Pick an ETF with an undiluted portfolio. For example, if you go in for a gold exchange traded fund, check if it is investing in the glittering metal alone. If a gold ETF is investing a sizable part of the corpus in debt and money market instruments, besides gold, the high returns from the glittering metal would not be seen.

A glance at the offer document easily reveals the portfolio allocation facts. Always keep away from smaller exchange traded funds. They don't give liquidity to the investor. Another danger is, they may not be traded at all.

No, to nav glitch

It's very important to scrutinise if the ETF is trading at a discount to shares. That is, although shares are doing well on the bourse, the units at the ETF might be traded at less than the market value of stocks.

For example, if a unit is Rs 4,500 on Nifty, check if the ETF is showing less, say Rs 4,400. There's no point in selecting an ETF, which sells units at lower prices persistently. The lag becomes bigger. The investor loses, as the difference tots up, gradually. For example, in a gold ETF, he may suffer a loss amounting to Rs 40-50 per gram.

The order book of NSE, which displays the prices and quantity of units being sold in the market, must be seen to avoid NAV problems. Also, investigate if the ETF creates new units or at least redeems these to fulfill a demand or supply mismatch in the secondary market. If yes, the NAV discount problem does not surface.

Be on right track

To choose an ETF, spot whether tracking error is low. Tracking error is the difference between ETF and market value. That is, a divergence is seen between the NAV and the underlying index. If the index is up 100 per cent, an investment of Rs 100 would not become Rs 200, but show, say, Rs 100 or Rs 150 only.

The reason why tracking errors occur are high management fees. A low tracking error, like 0.4 per cent, would not be detrimental. Tracking errors may also occur if the ETF holds cash to meet adjustments for merger, hive offs or dividend payouts.

Moving or not?

Is the ETF actively traded? That is, has pace been kept with market developments, if any? An inactive ETF would mean you can't exit holdings at the time or price of own choice. When the ETF declared a dividend, bonus or rights in the past, was this reflected in the returns which the investor got? Did it take time to reconcile or was there quick reconciliation?

Bid ask syndrome

An ideal ETF has a low bid/ask spread. 'Bid' means the investor should know the price at which he can buy units and 'ask' means he should know the price at which the seller is willing to give units. The difference between bid and ask should be very little, in an ETF. The fund chart would show both bid and ask figures.

Eschew expensive ETF

Brokerage is the most important expense an investor incurs while holding an ETF and determines how costly the venture would be, eventually. Whenever units are purchased or sold, brokerage has to be paid. Trading too much or trying to make profit from every small move shoots up costs. One way to cut costs is to scout for discount brokers.

They charge less commission and mostly operate online. All in all, the investor should try to keep brokerage expenses at 0.3 per cent. Check if the ETF is charging a host of expenses. These may include high investment management fees, trustee fees, investor communication fees, audit fees, cost of account statements, listing, license, marketing and selling costs and operating expenses.

The expense ratio is very important in the ETF scheme of things. Where it's 2 per cent, the meaning is 2 per cent of your NAV is spent on management costs! Annual management fees should not rise above 0.25 per cent.The fund offer document is the place to search for expenses.

A demat account is a must for investing in almost every exchange traded fund. Try a few smart strategies. For example, if you already are investing in stocks, and have a demat account, it can be used for exchange traded fund units, too. No demat account? Open one, but save on money.

Look for a demat account that does not ask for annual maintenance charges or one that waives account opening fee. You can also find a demat account that levies a flat fee or imposes brokerage fee only on volume traded. Coming to specifics, in a bond exchange traded fund, the investor must know that profitable returns can be wiped out if he buys and sells units through a third party. Because, trading fees would be imposed.

The index fund investor must guard against high tracking errors, as they are more liable to creep in, touching 2.5 per cent. While putting money in a gold exchange traded fund, the benchmark must be known.

For instance, if the London benchmark rating is being followed, not MCX, a difference in NAV and market price could result in a loss of Rs 35,200 by the end of day.

There is a mistaken notion that if one buys the same specific amount every month, returns would be seen. Called rupee cost averaging, this mode of investing, however, is of no use. In an ETF, it proves expensive. After entry ETF is accomplished, invest for more than one year, not less.

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Meenakshi Subramaniam in Mumbai
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