ETFs: Low cost alone should not sway your investment decision

But before you decide to invest in ETFs, here is what you should know.

Explaining the interest in ETFs

The government has mandated that the EPFO (employee provident fund organisation) invest up to 15 per cent of the net inflows in ETFs that track the Sensex and Nifty. That ensures continuous inflows into these ETFs. Government also opted  to sell its shares in central public sector undertakings as a part of the divestment process through the ETF route. Bharat 22 and Central Public Sector Enterprises (CPSE) ETFs are the two schemes floated by the government.

“Regulatory changes, along with other factors have contributed to the growth of ETFs,” said Vishal Jain, Head - ETF, Nippon India Mutual Fund. “Among the regulatory changes, Securities Exchange Board of India’s (SEBI) scheme re-categorization and Market Capitalisation definitions, Fair performance benchmarking and adoption of full trail commission for distributors, ensured that the investors consider ETFs,” Jain added.

The low cost of the index funds have also attracted investor attention. For example, the CPSE ETF charges less than one paisa for every Rs 100 invested in this fund towards expenses. ETFs tracking the Sensex and Nifty launched by fund houses such as HDFC, Nippon India, Aditya Birla, ICICI Prudential and Tata charge as low as five basis points towards expenses. A hundred basis points is equal to one percent point. Compare this to around 60 to 100 basis points charged by direct plans of actively managed large-cap equity funds and you would understand why inflows into ETFs tracking the equity indices are rising rapidly.

Many mutual fund schemes, especially the large-cap open-ended schemes found it difficult to beat the index, leading investors to move towards ETFs. “Globally, low-cost investing is gaining traction. At the same time, outperforming the benchmark indices, especially in the large-cap space, is becoming increasingly challenging. Both these factors are leading to money moving towards ETFs and Index Funds,” says Anil Ghelani, CFA - Head of Passive Investments & Products, DSP Investment Managers.

Expanding scope

Almost all large fund houses offer ETFs tracking bellwether indices such as the Nifty and Sensex. There are now ETFs that also track the Mid-cap 150 and Small-cap 250 indices available. Also, you have the choice of investing overseas (Nasdaq 100 index in the US) through the ETF route. If you aren’t comfortable with market capitalisation-based index ETFs, you can also consider investing in smart beta ETFs.

Debt ETFs too are on the anvil – Edelweiss Asset Management has won the mandate to launch the government’s debt CPSE ETF.

How to pick the right ETF?

The total expense ratio (TER) and tracking error are key metrics. Tracking error measures how closely a fund manager tracks the underlying index. Lower the tracking error, better. Both tracking error and total expense ratio are available on mutual fund websites and portals such as moneycontrol.

But here is a word of caution. Most ETFs have very low liquidity. Units of many ETFs may trade at rates far below or far higher than their NAVs at times. This means you may get to enter below NAV, but there is no assurance that you will get to exit at the fair value.

“Poor liquidity can negate the low total expense ratio advantage. Volume numbers and impact cost information are published by stock exchanges; hence this should be considered when deciding to invest in an ETF,” said Jain. Impact cost, simply put, is the cost a buyer or seller incurs while executing a transaction due to the prevailing liquidity condition. He also advises that investors consider the indicative NAV of ETF units declared on the fund house’s website to ascertain if the units are trading close to the NAV. For example, the last traded price of Nippon India ETF Nifty BEES on the National Stock Exchange was Rs 1263, whereas the indicative NAV was Rs 1265.2, on November 11.

Should you invest?

There are two factors you should keep in mind in addition to the factors mentioned above. First, consider an investment product that fits your needs. “You must study the purpose of the mutual fund product (be it an ETF or index fund), and ascertain if it serves your specific investment needs,” said Ghelani. Do not buy an ETF just because it is a new theme available. It should fit within your stated asset allocation pattern in your financial plan and help you reach your financial goals.

The second factor is the overall cost of ownership of ETFs. Though the total expense ratio of an ETF is very low compared to that of an actively managed fund, it is not the only cost investors pay. There are brokerage charges every time they buy or sell. Additionally, there are demat account charges, which include the annual maintenance and the depository expenses every time the investor sells. This does inflate the total expenses as a percentage of your investments, especially if you are a small investor. Here is an example of how it works and may vary as the assumptions pertaining to the costs change.

In the above example, though the total expense ratio of the ETF is seven basis points, if the investor trades in the units within one year, then after accounting for brokerage and demat charges, the total cost of ownership goes up to 41.6 basis points.

Before you opt to invest through the ETF route, make sure that you do a thorough cost-benefit analysis.

If you do not have a demat account or you are not keen to take the trouble of placing orders regularly on the stock exchange, you can also consider investing in an index fund. Open-ended index funds are ideal vehicles for investors looking for passive investments with a long-term horizon. The minimum investments start with as low as Rs 1000 per month and you can enrol for systematic investment plans as well.