A lot of investors are inclined to compare ETFs on the basis of their previous returns only, believing that higher returns indicate a better performance. Though returns are important, they do not provide a full picture of the performance of an ETF over time. A wiser course of action is to examine various factors that impact consistency, cost, and risk.
Trusting historical returns solely can prove to be misleading, particularly when market conditions are constantly changing. It is not necessary that ETFs that performed successfully in the past will carry on the same trend in the future. That is why investors should dig deeper and consider other significant metrics.
Look at the expense ratio
The expense ratio is the cost that the fund charges to manage your investment every year. It might appear small, but it directly reduces your total returns over time. Lower expense ratios are usually more favourable for long-term investors.
When comparing ETFs, always examine the amount of cost you are incurring for similar exposure. Even a small margin of 0.2% can have a visible effect in the span of several years. This is even more crucial when you compare ETF options of the same category.
Check tracking error
Tracking error measures the gap between the actual return of the ETF and its underlying index’s return. Ideally, an ETF is supposed to mirror the performance of the index with very little deviation. When the tracking error is lower, it is a sign of better fund efficiency.
Even when the index is performing well, a high tracking error can decrease the expected returns. It usually comes about because of costs, cash holdings, or imperfect replication strategies. Thus, investors are always advised to invest in ETFs with consistent and low tracking error.
Understand the underlying index
All ETFs are designed to track a given index, and it is important to understand that index. The index dictates the sectors, companies, and the general risk exposure of the ETF. It also affects the ETF’s behaviour in various market conditions.
As an example, the Mirae Asset Nifty Metal ETF tracks the Nifty Metal Index, which is largely reliant on metal and commodity stocks. This type of sector-specific ETF may be more volatile than a diversified index. Understanding this assists investors in investing according to their risk-taking capacity.
Evaluate liquidity
Liquidity is the ease with which you can sell or purchase an ETF in the market. Increased liquidity means the ease of transactions and improved price execution. It tends to be reflected in trading volume and bid-ask spread.
Low liquidity can result in higher spreads, raising the cost of trading. This can affect your returns, especially if you trade frequently. This may influence your returns, particularly when you trade very often. Hence, selecting ETFs that have high liquidity is crucial for effective investing.
Review fund size (AUM)
Assets Under Management (AUM) suggest the total capital invested in an ETF. The larger the AUM, the more the ETF can be said to be stable and more accepted by investors. It also minimises the risk of fund closure.
Smaller ETFs can experience difficulties such as low liquidity or increased costs. Although they are not necessarily bad, they should be evaluated more carefully. ETFs that have a moderate and increasing AUM should be more favoured by investors.
Consider risk metrics
Risk metrics allow you to know how volatile an ETF is and how it is performing against risk. Measures like standard deviation and Sharpe ratio are commonly used. They give a more realistic image than returns alone.
An ETF with slightly lower returns but lower risk may be a better choice for long-term investing. This reason is that it provides more stable performance in times of market volatility. Always weigh risk and return before making decisions.
Conclusion
Comparing ETFs solely on the basis of their past returns results in incomplete and, at times, risky decisions. Aspects such as cost, tracking accuracy, liquidity, and risk are equally crucial in overall performance. A holistic method assists investors in making better decisions.
Investors can use these parameters to determine ETFs that meet their financial objectives. This provides a high level of consistency and prevents unpleasant surprises in the long-term. An informed comparison would always result in wiser investing decisions.
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