​Looking for an ETF that suits you? Refer to the VICTER scale

Over the last couple of years Exchange Traded Funds (ETFs) have become a popular investment option. A passive ETF is a type of fund that tracks a specific index or sector. These funds allow you to diversify your portfolio without the burden of researching numerous individual companies. However, most investor do not understand that ETFs are created equal! Choosing the right ETF is key to ETF investing. VICTER framework can help you choose an ETF that is right for you:

Average Daily Trading Volume

If you have ever invested in stocks directly, you may know that it is easy to buy and sell stocks with high liquidity. Since ETFs have properties similar to stocks, it is advisable to select ETFs that have higher liquidity. The average daily trading volume of the ETF shows how easily we can expect its holdings to be liquidated. Generally, ETFs with higher liquidity have a lower bid-ask spread and vice versa. In simple words, ETFs with high liquidity and lower bid-ask spread are easier to sell. Hence, one must choose an ETF with higher volume.

Impact Cost

The liquidity of ETFs is related to their impact cost. It is the cost attributable to lack of market liquidity. Lack of liquidity translates into a high cost for buyers and sellers. ETFs that have higher liquidity will have a lower impact cost.

Let us simplify it with an example:
Assume that you want to buy 5,000 units of an ETF. A best-buy order for 1,000 ETF units at Rs.980 and best-sell order for 2,000 ETF units at Rs.982 are displayed on the National Stock Exchange (NSE) terminal. As a result, the average price — Rs.981 — should be the ideal pricing. However, if you had to purchase 5,000 shares of that ETF for Rs.991 on average, your impact cost is 1%, i.e. (991-981)/981. This means that due to the ETF’s liquidity, you paid 1% indirectly as a transaction cost to buy 5,000 units. The difference between the best buy and the best sell orders (in this case, Rs.2) is the bid-ask spread. Hence, if a person buys 1,000 shares and sells them immediately, he is poorer by the bid-ask spread. This spread may be regarded as the transaction cost which the market charges for the privilege of trading.
The impact cost for ETFs that are liquid is low. So, impact cost is the second aspect you need to consider while selecting an ETF. One must choose an ETF with lower impact cost.

Tracking Error

A passively managed ETF aims to provide returns similar to the underlying benchmark. However, there is a difference between the returns from the benchmark and ETF. The standard deviation of summation of such differences over a period of time is called the tracking error.
Tracking error is caused due to various reasons such as fees and expenses of the scheme, cash balance held by the scheme due to dividend received subscriptions, redemption, etc, dividend payout of the underlying constituents, halt in trading on the stock exchange due to circuit filter rules, etc. The ETF fund managers track the tracking error regularly and aim to keep the tracking error as low as possible.
Since a low tracking error means that the ETF returns will be closer to the index’s return, it is important to invest in an ETF with a low tracking error.

Total Expense Ratio (TER)

One of the reasons behind the tracking error of ETF is the Total Expense Ratio (TER). An expense ratio is an annual fee charged by a fund to pay for its expenses. If an ETF’s expense ratio is 0.20%, it means that 0.20% of the fund’s assets are charged to manage the fund. We might see different expense ratios among various mutual funds that track the same index.
The expense ratio is deducted from the ETF’s NAV. So, a higher expense ratio may lead to a higher difference in the returns between the ETF and the index. Hence, it is best to invest in ETFs that have a lower expense ratio, however this parameter must be taken together with the other three.

Wrapping up

Selecting the right ETF may be difficult for individual investors. To make it easier, we have introduced VICTER: Average Daily Trading Volume, Impact Cost, Tracking Error, Expense Ratio — the four parameters that you should consider while choosing an ETF.