Since their launch in 1993, Exchange-Traded Funds (ETFs) have come a long way from being mere equity-index trackers. ETFs have opened up a whole new world of opportunities for investors. They have drastically expanded investment possibilities across asset classes, geographical regions, and investment strategies.
An ETF is a basket of securities that tracks an index, equities, commodities, currencies or other asset classes. They can be structured to track anything, from an individual commodity to a large collection of securities or a mixture of several types of investments like stocks, bonds and commodities. ETFs can even be structured to track specific investment strategies.
A well-known ETF is the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index. You can trade an ETF just like you trade shares on the stock exchange.
- Liquidity: This is a measure of how consistently the stock is sold or bought without affecting the price of shares.
- Portfolio diversification: This is various underlying investments to balance risk and return.
- Affordable: ETFs are cheaper despite of numbers of underlying investments, and have relatively lower operating cost compared to actively managed funds.
- Transparency: Since ETF holdings are disclosed daily, it provides a higher level of transparency for the investors.
For an investor, it is crucial to have a look at the performance of the ETFs. There is internet-based software called ETF screener to add funds and compare them based on various parameters. ETF Screener allows you to filter through all the funds and eliminates the guesswork while comparing ETFs.
Since an ETF is to track an index, you can assess the ETF by weighing the fees the fund charges against how closely the ETF matches the index performance.
There are two costs you will incur when buying ETFs: transaction costs and annual management fees. Transaction costs are the fees you pay when you buy and sell the ETF. Annual management fees combine asset-management costs, bank charges, audit fees and taxes that the ETF may have to pay on its investments. Adding these will give you the total cost of owning the ETF.
The two ways to see how closely an ETF matches the performance of the index it tracks are tracking error and tracking difference.
Tracking difference is the difference between an ETF’s performance and its index performance.
Tracking error measures the volatility in the difference of performance between the ETF and its index.
- Holdings: Like mutual funds, ETFs give investors exposure to a basket of securities with the purchase of a single ETF.
- Benchmark Selection of ETF: It is a tool utilised by investors to analyse the portfolio’s allocation, risk, and return factor. It is generally constructed with the help of unmanaged indices, ETF or mutual funds.
- Underlying assets or index: The underlying asset or index of an ETF plays a crucial role in the ETF’s performance. Since the ETF tracks its underlying asset or index, the better these perform, the better should be the ETF’s performance, all things being equal.
Independent of portfolio
- Fund expenses: Investors should look out for funds with lower expense ratios.
- Liquidity: Liquidity refers to the ease of converting an ETF’s assets into cash or cash equivalent. The primary factors that influence an ETF’s liquidity are the composition of the ETF and the trading volume of the individual securities that make up the ETF. The higher the liquidity, the better it is for the ETF and investors, as they would not have problems selling their ETF later.
There are other factors like portfolio optimization, risk exposure, portfolio turnover rates and security strategies that can affect the performance of an ETF. One should always look at the level of assets, trading volume of the index and the value of the underlying stocks before investing in an ETF. ETFs have experienced significant growth because they are highly efficient investment vehicles. Still, this does not mean that all ETFs are equally efficient. Investors ought to assess a fund’s expense ratio, tracking results and capital gains history etc., when evaluating an ETF.
*This is not financial or investment advice. Remember to do your own research and speak to a professional advisor before parting with any money.