Exchange-traded funds (ETFs) are similar to mutual funds as they provide investors broad diversification, professional management, relative low cost, and daily liquidity. However, ETFs take the benefits of mutual fund investing to the next level. ETFs offer lower operating costs than traditional open-ended mutual funds, greater transparency, are tax efficient and provide greater liquidity as they can be bought or sold throughout a trading day. The ETFs’ trading value is based on the net asset value of the underlying stocks that they represent.
ETFs, thus, are an attractive option for investors who have a flavor for investing in the stock markets through mutual funds. However, there are certain factors which an investor should take into consideration before investing in an ETF:
1. Investment Objective: The person willing to invest in an ETF should have a clear and well-defined investment objective, for e.g. does he want to invest in a broad market index, a specific sector or a region or wants to follow a thematic investment approach? Once the investment objective is clear, the investor can choose from the ETFs catering to his particular investment choice.
For example, broad-market or index-based ETFs can be a low-cost, well-diversified option with potential tax-efficient components for an investment portfolio. However, “there is a need to do a lot of research, since those products track the performance of the corresponding index, minus expenses. While investing to gain sector or theme exposure, it’s crucial to know which stocks are owned within the ETF. Exchange-traded funds concentrating in specific industries are subject to higher risks and volatility than those that invest more broadly. Determining the correct investment strategy will set you on the correct path of picking the most effective ETF,” says Rahul Agarwal, Director, Wealth Discovery Securities.
2. Risk: Like all investment instruments, ETFs are subject to market risk. Knowing your risk tolerance is important. The principal risks are typically those associated with the ETFs’ investment objective, such as adverse developments in the securities or market segment in which the ETF invests, or related developments such as interest rate or currency fluctuations.
In addition to market or sector-specific risk, there are other risks that are not so apparent. For example, “the risk of index-based strategies is tracking difference between the returns in the index and the returns presented by the ETF. Index based funds that show big divergence between these two returns are inherently risky. Another risk for all ETFs is premium/ discount volatility (i.e., changes in the difference between the market price of ETF shares and the market value of the underlying assets). ETF which shows higher volatility in comparison to the underlying assets should be avoided at all costs,” informs Agarwal.
3. Costs: You should also consider all the costs associated with owning an ETF. One of the benefits of investing in ETFs is their low-cost nature. However, the published expense ratio only covers management, administration, custody and auditing fees. There are various additional costs that aren’t included in the expense ratio, such as brokerage fees, rebalancing costs and trading spreads. You should understand the total cost of investing prior to making an investment decision.
4. Tax: Another factor to consider is taxation of the ETF. Most products have a structure that is taxed at capital gains rates. However, there are some ETFs, for e.g. gold ETF, that have different holding periods to qualify to avail long-term capital gains benefit. You should consult your tax advisor before making an investment in an ETF. “Gold Exchange Traded Funds attract short-term capital gains as per one’s income tax slab. In case of long-term capital gains, however, Gold ETFs attract 10 percent tax without indexation or 20 percent with indexation. Index-based ETFs, however, are taxed differently. Tax on index ETFs is very much different when compared to the taxation on gold ETFs. The short-term capital gains tax on these instruments is levied at 15 per cent, while there is no capital gains tax in the long term. Index ETFs currently attract a Securities Transaction Tax of 0.125 per cent,” says Agarwal.
5. Assets Under Management (AUM): AUM is the total market value of assets that an investment company or financial institution manages on behalf of investors. As a general rule, investors should consider those funds which have higher AUM. This will help them in reducing their chances of running into a mismanaged or unprofitable fund, and lower their liquidity risk. Investors should not necessarily ignore lower-AUM funds as there are well-managed niche ETFs that are also available in the market at all times.