… Continued from Part 1 (ETF: Better investment option today)

Are ETFs like index funds?

Exchange traded fund (ETFs) and index mutual funds both seek to match the return of a market index. Both suit investors looking for diversification. However, there are important differences. The first is the minimum investment. For investors with limited funds (say, less than Rs 1,000) who want to get started in the stock market, ETFs offer a cheap entry option — you can buy even one lone share, if you so choose. Index mutual funds require a minimum investment of Rs 5,000.

Another difference is ease of use. ETFs can be bought or sold any time the market is open, via your brokerage account. There are no hassles of filling up application or redemption forms, since you hold ETF units in your demat account. Index funds, on the other hand, can only be redeemed at the closing price of each day. A third difference is in tracking error, which determines how closely an ETF mirrors the return of the underlying index. Generally, the tracking error of an ETF is lower than that of an index fund, indicating better replication of the underlying asset. Fourthly, the expense ratio is generally lower for ETFs. And lastly, index futures give you tax benefits on only shortterm capital gains, while ETFs give you long-term capital gains benefits, too.

Are ETFs for me?

Here are some guidelines to help you know when to consider an ETF — and when not to consider:

• If you’re trying to get market returns, or believe the index will yield good long-term returns, ETFs may be a good choice because of their low cost and diversification. But ETFs make little sense if you’re trying to beat the market, since they only track market indices.
• When you’re looking for wide diversification but have only a small sum to invest, an ETF may make sense.
• When you’re unsure what to buy, but want to invest in equity, an ETF lets you invest in the stock market without betting on a particular company.
• Do a background check: As with any investment, there’s no substitute for doing your homework to ensure that you get what you pay for, and that it suits your needs.
• Read the ETF prospectus carefully. Make sure you understand the index or underlying asset it’s based on, the risks associated with the index or asset, and how it fits into your portfolio. 
• Scrutinise an ETF’s holdings. Make sure the fund’s label matches the underlying securities you want to buy. 
• The most valid criterion for evaluating an ETF is tracking error. Make sure your ETF has a low tracking error, otherwise your investing objective is not completely achieved.
• And lastly, make sure you understand costs such as management fee and brokerage. 
• To sum up, then, exchange traded funds are best used as a long-term investment tool, ideal for filling asset allocation gaps and replacing higher-fee mutual funds.