How to Choose an ETF

ETFs, also known as Exchange-Traded Funds, have become quite popular among investors looking for a way to invest in assets like stocks, bonds, gold, commodities, and real estate. Their ease of use, quick tradeability, and growth potential have captured the interest of both novice and experienced investors.

Simply put, an ETF is a basket of investment securities that can be bought and sold like individual stocks on a stock exchange. If you invest in ETFs, you can simplify the management of your portfolio and potentially reduce the risk associated with picking individual stocks.

In this blog, let us see how to choose an ETF based on your financial objectives and ambitions.
 

Key takeaways

• Before choosing an ETF, determine your investment objectives, risk appetite, and investment horizon to select the one that meets your needs.
• Consider factors such as the fund's size, age, trading volume, and costs.
• Larger, well-established ETFs with higher liquidity and lower expense ratios are often preferable.

Before you learn how to choose an ETF, you must create an investment plan that takes into account the following factors:

• Financial objectives
• The current composition and allocation of different investments and assets in your portfolio
• The maturity period or time horizon that you want to stay invested
• Risk appetite

These factors will help you gauge your risk tolerance, which, in turn, will guide you towards selecting the right ETF options for your capital growth.

This is an important question to answer as it will help you determine the true objective of your investment and help you select the right ETF. Different investors have different objectives; for some, it could be diversification of their portfolio or having an alternative to investing in individual stocks. For others, it could be a way to achieve specific investment goals with lower risk and cost.
 

For instance, if your objective is diversification of portfolio, the right approach towards selecting an ETF should be to opt for one that you do not already have exposure to in your portfolio. An ETF that tracks all the major companies and stocks of that particular industry will help you achieve diversification.
 

Similarly, for some investors, the objective could be investing in equity instruments since they are already heavily invested in debt investments. Hence, understanding your motivation behind investing in ETFs is essential. Here are a few questions you could ask yourself to make better decisions:

• Is diversification in the portfolio your only objective?
• Keeping in mind your current portfolio and risk appetite, which are the ETF categories you should consider? Should it be equity, debt, commodities, or others?
• Do you plan on holding onto the ETFs for the long term or do you plan on trading them actively?
• Are you eyeing any specific sectors to gain more exposure to?

After answering the above questions, you will have a better understanding of which ETFs will meet your unique needs and demands. You will be better able to compare different ETFs and zero in on the ones that are most suitable for your current plans.

Once you have identified the above parameters, it is time to answer, ‘How to choose an ETF?’

Here are some fundamental factors that you need to consider:
 

1. Size of the fund:

ETFs that have a large fund size are indicative of higher investor interest, greater liquidity, and lower fees. Therefore, experts think that investors should opt for funds with a larger size over smaller ones.

2. Age of the ETF:

ETFs have been a popular investment vehicle for more than two decades now. Although new funds are being launched every year, many funds in the market have historical data that you can rely on to assess their past performance. However, this cannot be the sole criterion, as past performances do not guarantee future success.

3. Volume of trade:

What makes a mutual fund different from an ETF is that units of an ETF can be traded on the stock market, provided the given ETF also has a demand. Before investing, check the ETF's trading volume. Look for any declining trends and investigate the underlying causes to make an informed decision.

4. Costs:

While investing, the goal of an investor is to maximise profits, minimise risks, and look for instruments that have minimal costs associated with them during buying and selling to generate more returns.

Mutual funds, for instance, have expense ratios that take into consideration various administration charges. ETFs, on the other hand, are managed passively and hence, their expense ratio is lower.

Therefore, when comparing two ETFs of similar quality, you might prefer the one with a lower expense ratio. This is because transactions on stock exchanges come with additional costs.

5. Tracking error:

If you invest in an ETF that tracks a specific index, then the manager of the fund will aim to purchase securities in a way that aligns the fund's returns with those of the underlying index. However, the fund manager will not buy all the securities that are a part of the specific index, which could lead to the possibility of there being a difference in the returns between the ETF and the index. This is what is known as a tracking error. When the error is on the lower side, it means that the ETF has given returns close to the index.