BEGIN INVESTING WITH ETFs

So you want to start investing and don’t know where to start?

This post will outline key concepts and then provide links to actually start investing…check this post regularly over the next few weeks

What is investing?

We have provided a high level outline with links to 18 one-minute videos in this post …please watch this series for a refresher on key terms and concepts.

What is active vs passive investing?

Ok, now let’s explain active vs passive investing.

Most mutual funds you see advertised are active funds. The fund manager has to think hard to come up with an investment philosophy about which parts of the market are inefficient and then a style and process of how his team pick stocks to be able to produce higher returns than the index. Of course, the team has to get paid. Marketing costs money too. And then there’s the commission to the distributor for helping to select the fund. These fees and expenses add up to a relatively high expense ratio built into the fund structure.

As an investor, you have to study 1) if these active funds can add value… 2) when they do and don’t add value. But then 3) you realise you don’t know how to pick those ‘best funds’ in advance.

Now in normal circumstances, good economic growth leads to stock market growth captured by market indices. So you can invest in an ‘index fund’ which aims to match index returns.

It’s also called ‘passive investing’ because the fund manager doesn’t have to do any research but simply buy the same stocks in the same proportion as the index. Or figure another way to get the same return. Either way, index funds aim to get the same return as the index.

How do active and passive funds invest?

When the index provider makes a change, the index fund manager needs to quickly buy the same stocks but ends up paying a little more. That means her returns will be a little less. Secondly, the index is hypothetical, so fully made of stocks, while in real life, funds have to keep a small part of the fund in cash so that they are able to meet investors’ redemption requests on a daily basis. So the index funds return tends to be mostly slightly lower than the index.

The active fund manager can hold stocks in different proportions or indeed completely different stocks to the index outside of the top 30 or 50 stocks he is compared to. He has to pick stocks based on his views on size, themes and sectors, as well as stock specific style factors such as value or growth.

The degree to which the performance of any fund has been away from the index returns over any given period is called tracking error. You would want this to be very low for index funds, and reasonably high for good active funds to get your fees worth.

What’s the difference between index funds and ETFs?

Remember index funds are basically mutual funds that try to track – or give the same returns – as the index. ETFs also track indices so what’s the difference?

The index mutual fund manager has to buy all the stocks in the index the day after you invest. The delay and quantum of buying means she buys at slightly higher price. She also needs to hold some cash to allow investors to redeem on a daily basis. Hence, the fund performance doesn’t quite track…it have a small ‘tracking error.’

Now imagine the index fund itself gets listed on the stock exchange. This means that investors can buy and sell on the exchange, hence, the name ‘exchange traded fund’. So the fund does NOT need to keep any cash. The result is..the performance of ETF shows a lower tracking error than index funds.

If you worried if your ETF will be liquid enough when you need to sell, don’t worry. The ETF eco-system includes Market Makers, who can buy from or sell to you to ensure liquidity. And if the volume is really big, there are also Authorized Participants, who can do in-specie trades with the AMC, meaning they can compile baskets of shares to trade for ETF units, so that the ETF prices don’t show too much premium or discount to the underlying NAV.

How can we start investing in ETFs?

To begin investing in ETFs, you just need a demat account and a broker. You can sign up at a discount broker like Zerodha or Upstox. You then look up the stock codes for the ETFs just like you would for a company stock.

If you need help with selecting ETFs, you can do your own research. But then you also have to keep an eye out just in case their performance doesn’t track properly, and also re-balance if you have invested in multiple asset classes.

You may want to check out some new age portfolio managers that offer pre-set model portfolios. (I will post some names here soon).

Frequently asked questions (FAQs)

Now let’s turn to the most frequently asked questions we get on ETFs –