Understanding ETFs

First thing first, what is an index? 

In simple terms, an index is a record that can be used for navigating and understanding the key information in a set of records. For a book, an index is a list of keywords with page numbers to find information associated with that word. 

In the world of investing it is a combination of stocks that are looked together to decide on how the market, sector, theme or idea is doing. Therefore, it functions as an indicator, since it is showing the impact of the underlying. 

What is an ETF?

Now if someone decides to make an instrument from this index to invest in and make it available on the stock exchange then that instrument will be called Exchange Traded Funds. 

It is a fairly simple product that just tracks an indicator. Therefore, by investing in an exchange-traded fund, you're efficiently investing in the underlying index. Your returns will also be near to that indicator.

For example, in case you have invested in a Sensex or even a Nifty Exchange-traded fund, you'd get comparable returns as people from all of these indices. A look at available exchange-traded fund options in India reveals that there are 26 ETFs monitoring the Sensex or Nifty indices.

You might ask, what is the distinction between them? If all of them track the same index, should not you pick one randomly? Well, not really, since there are differences among the ETFs that track the same index.

Here are the different parameters you should bear in mind while choosing an ETF.

Underlying indicator: An Exchange-traded fund tracks an index, so first choose which index you want to put money into. Sensex and Nifty include large-cap stocks. Therefore, by investing in ETFs that track them you are investing in massive caps. There are ETFs monitoring small and medium caps as well. Then there are those who follow international indices. 

Ease of replicability: Large-cap indices constitute the majority of liquid stocks and therefore it is easy for the finance manager to imitate them. On the flip side, ETFs monitoring mid and small caps must fight more difficulty to replicate their inherent, given that these segments have a tendency to be liquid.

Liquidity: While buying an ETF, it's very important to ensure you can purchase and sell its components with ease. Therefore, it's very important to choose an exchange-traded fund that trades with a pretty large trading volume. This is comparable to investing in liquid or illiquid stocks. A liquid inventory gives you the ease of selling and buying. However, with illiquid stock, your order can remain unexecuted for quite a long time.

What would be an underlying challenge to the ETF?

Brokerage costs and illiquidity can be a great problem for any ETF. 

If your broker has a high cost for buying and selling the ETF then it can increase your transaction costs. Thus, it could create a challenge for investors. 

Should we invest in ETF?

Only if the individual understands the risk and the kind of opportunity that the product allows. For Indian investors, an index fund is a superior option from a liquidity perspective, as there are regulations on mandates in terms of dilution of portfolio and meeting the redemption requests. Those who are still confident of their prowess may choose it.