Understand how ETFs work
ETFs are passive index funds traded on stock exchanges like stocks. They track and replicate the composition and performance of market benchmarks like Nifty 50 or Sensex. Buying an ETF unit gives exposure to the underlying index it tracks. ETFs combine the diversification of mutual funds with the flexibility of stocks. Learning how ETFs are created, priced and traded is vital for effective usage.
Choose the right index
With numerous ETFs linked to indices across assets like equities, bonds, gold etc., picking the right index-linked ETF that matches your goals and risk appetite is crucial. Assess if you want market-cap based ETFs like Nifty 50, factor/strategy ETFs or sectoral ETFs. Evaluate historical returns and volatility before selection. Actively managed ETFs require more due diligence on fund managers' strategies.
Keep costs low
A key benefit of ETFs lies in their low expense ratios given the passive indexing approach. However, additional costs like brokerage, bid-ask spreads and taxes apply on ETFs. New investor-class ETFs levy lower brokerage and fees. Opt for direct plans of ETFs over regular ones. Use discount brokers offering low charges. Maintain long holding periods to minimize the impact of trading costs. Keeping costs low ensures better realized returns.
Monitor liquidity
ETFs being listed on exchanges provide ready liquidity via intra-day trading. However, many ETFs in India suffer from low daily volumes and wide bid-ask spreads. Stick to ETFs with higher average volumes and tighter spreads. Limit orders can secure better pricing vs market orders. Overall, index ETFs enjoy better liquidity than niche ETFs. Factor liquidity against your investment timeframe before selecting an ETF.
Use multiple ETFs strategically
Maintain prudence while choosing ETFs to avoid overlaps. Blend ETFs covering diverse segments like large-cap, mid-cap, sectors, themes etc to optimize risk-return profile. Alternatively, a single diversified ETF like Nifty 50 can effectively cover the broader market. Rebalancing periodically to align with target allocations is advised. Limit total ETFs to 4-5 for simplicity. The strategic use of multiple ETFs drives diversification.
Employ passive investing principles
The core appeal of ETFs lies in passive indexing that delivers market returns at low costs. Avoid actively trading ETFs to time markets, which increases costs and risks. Patiently invest in ETFs through SIPs allowing compounding over long periods. Redeem only closer to goals. Ignore short-term volatility and maintain investment discipline. Passive investing principles suited for ETFs lead to positive outcomes.
Utilise the flexibility offered by ETFs
ETFs offer flexibility in managing investments. You can buy, sell or switch ETFs anytime during market hours at actual NAVs unlike open-ended funds. Swing trading, hedging using inverse ETFs, collateralizing ETF units and using tailored structured products are possible for savvy investors. You can redeem ETF units for the underlying stocks too. Based on your sophistication, utilize ETF-specific flexibilities appropriately.
Review periodically
Keep monitoring your ETFs periodically for performance, tracking error, costs, liquidity and portfolio suitability. Review new index-linked or strategic ETF launches. Exit ETFs if the index composition changes materially over time. Evaluate switch opportunities to better ETFs. Like mutual funds, review ETF holdings at least yearly to ensure they continue meeting your needs. Periodic reviews help sustain ETF returns.
By understanding ETF mechanics, choosing low-cost diversified ETFs, following passive strategies and harnessing ETF flexibility prudently, Indian investors can leverage exchange-traded funds effectively to achieve their financial goals.