Ruby McKenzie
An Exchange Traded Fund (ETF) is a marketable security that provides exposure to a basket of securities that could include stocks or bonds, or commodities. They are traded on the stock exchange, just like individual shares, and combine the diversification of mutual funds with the flexibility of stock trading.
Want the best ETF to invest in? For that, you need to define your financial goals, measure your risk appetite, assess the ETF’s structure, review expense ratios, study performance history, and address several other factors. Let’s go through these aspects in more detail below.
Know your risk appetite
Some exchange traded funds track volatile markets, while others are more stable. Assess your comfort with risk before you invest in ETFs. If you can digest market swings, sectoral or thematic ETFs like those focused on technology or pharmaceuticals might interest you more. If not, broad-based ETFs like the Nifty 100 could provide stability.
Understand the ETF structure
ETFs track several assets like stocks, bonds, commodities, or indices. Before investing, make sure to understand the various types of ETFs available to invest in:
- Equity ETFs: Invest in a basket of stocks.
- Bond ETFs: Focus on fixed-income securities like government or corporate bonds.
- Commodity ETFs: Target commodities such as gold, silver, or oil.
- Sector and thematic ETFs: Invest in specific industries like technology, healthcare, or energy.
- International ETFs: Offer exposure to foreign markets or global indices.
By understanding your goals and ETF structure, you can decide on the best ETFs to buy that match your investment strategy and return expectations.
Compare expense ratios
The expense ratio is the annual fee charged by the fund house for managing the ETF, which directly affects your returns over time.
For example, if two ETFsoffer similar returns, but one has an expense ratio of 0.3% and the other 1%, the lower-cost option saves you money. On an investment of ₹10 lakh, the first ETF would cost ₹3,000 per year, while the second would cost ₹10,000. Hence, lower expense ratios help you retain more of your earnings. However, it is wise to look for other crucial factors also while choosing an ETF.
Assess the trading volume
Trading volume is a critical factor to consider when choosing an ETF, as higher trading volumes indicate better liquidity. Liquidity ensures that you can easily buy or sell the ETF without significantly impacting its price. Low trading volume can lead to wider bid-ask spreads, meaning you might pay more to buy or receive less when selling. Always check the trading volume to ensure smooth transactions and fair pricing.
Check the tracking error
Tracking error measures how closely an ETF mirrors the performance of its underlying index. While the goal is to match the index almost exactly, factors like fund management fees, market conditions, or timing of trades can cause deviations. A lower tracking error is considered more ideal, as it indicates the ETF is tracking the index as closely as it should. Consistently high tracking error suggests inefficiencies and may lead to reduced returns.
Key takeaways
By now, you should have a clear understanding of how to buy ETFs that are right for your financial goals and risk profile. Consider factors such as your risk profile, types of ETFs available, trading volume, expense ratio, and tracking error.
By focusing on these aspects, you can make well-informed decisions and build a portfolio that meets your objectives and expected returns. After you invest in ETFs, make sure to regularly review your portfolio and make adjustments as needed to stay on track.
