Prime ETF Ratings

Average turnover is based on the average 3-month traded value. Returns greater than 1 year are annualized. Returns are based on NAV and not market price.

• ETFs that are less than a year old are not rated. This is a gating criterion to ensure we have sufficient time to study tracking error and turnover.
• Sector/thematic/strategic ETFs which lack open-source data for benchmark have not been rated. 
• Liquid and debt ETFs for which underlying index data is available have been rated, and the rest are unrated. As and when such index data becomes available, we will start rating these ETFs.
• The rating considers factors such as expense ratio, AUM, tracking error over multiple time frames, average turnover and deviation of market price from NAV. Tracking error is the deviation in returns of the ETF from the index it tracks. It also takes into account the deviation of the market price of the ETF from its NAV. 

Three things you should know before buying ETFs

When it comes to owning ETFs, there are three things you need to know – both for buying them and reviewing them. One is the cost of the ETF, second is the liquidity and impact cost and third tracking error. All three are important for an ETF to deliver closer to the index it is tracking. Let’s discuss these a bit more. But before that, for beginners, here’s a detailed FAQ on what ETFs are, how they work and how you can use them.

Cost of an ETF

Most of us look at expense ratio and assume that is the only cost incurred in an ETF. However, there are several other direct costs – such as brokerage for buying, for selling, the GST on such brokerage demat charges, dividend tax if the ETF declares dividends and then finally the bid-ask spread both at the time of buying and selling. The last mentioned-point, is an impact that is often missed out by many.

To explain, bid-ask spread is the difference between the price at which someone is willing to sell (ask) and the price that one is willing to pay (bid) to buy a stock at a given point I time. When this spread is wider, it costs you more to trade in an ETF. ETFs that are well managed tend to keep this difference tight. Typically, an ETF that is well traded may have a lower spread while those that are less liquid may have a higher spread. Thus, there is an ‘impact cost’ on account of this when you buy an ETF.

Volume/liquidity of ETF traded

It is not just the bid-ask spread that impacts cost. You can have an ETF will low volumes that has a tight bid-ask spread and an ETF with higher volumes, with the same bid-ask spread. If you try to buy an ETF with poor volume, your buying action may significantly impact the price (pushing it up) – also called the market impact. Also, when you hold such low volume ETFs, you may not be able to sell it at the market price at which you are seeking to sell, if you hold substantial quantities and the traded volume is thin. So you may end up selling at a price lower than you ought to have.

When an ETF has lower supply and higher demand, its market price tends to deviate away from its NAV. It trades at a premium to the NAV. Hence, you will be buying it at a price that is higher than the real value. The reverse is also true. But that does not mean you have a ‘value buy’ in ETFs where the price is trading lower than the NAV (demand is lower than supply). Chances are, when you try to sell them, you may lose as there will be fewer takers or no takers. Well-managed ETFs try to manage this demand-supply position with the help of market makers to ensure the market price is not way away from its NAV.

Tracking error

When you buy an ETF you expect it to mimic the performance of the index it is tracking. But in reality, it cannot track its index 100%. There are several reasons for this: one, there is the expense ratio. The returns of an ETF is that of the index less the expense ratio. So in reality, this cost will reduce returns, albeit marginally.

Two, there can be difference in returns that arise when rebalancing the portfolio. When an index reconstitutes itself, the changes are immediate. An ETF, though, must make those changes by transacting – that is buying or selling stocks. Any difference that occurs in this time can lead to marginal difference in the ETF’s performance versus the index. Sometimes even as small amount of cash in the ETF can result in a drag.

Such deviations of the ETF from the index’ performance is called the tracking error. It is calculated by taking the daily difference between the index and the fund and calculating the annualized standard deviation. In other words, it is the volatility of the difference. Sometimes, this number can also be negative when the ETF gains during its rebalancing transaction etc. But these are anomalies and most of the time the ETF marginally tracks the index.

If the tracking error is high, then it means that the ETF is not managing its cost or rebalancing well. An ETF with high tracking error means that its performance will be more out of sync with the index. Hence, in choosing an ETF, the one with low tracking error, besides other factors such as volume should be looked for.

There are also a few other points you might want to keep in mind when it comes to ETFs:

• What you see as returns for ETF in many places is based on the ETF NAV and not the market price
• Tracking error in most databases provide the deviation between the ETF NAV returns and the index and not the ETF market price returns and the index.
• ETFs can declare dividend, either added as units or as cash. Hence, their NAV and market price will fall to that extent. So, how you compare them with index matters (TRI or just the index).
• Comparing ETF returns (based on market price or NAV) directly with index fund returns may not also be correct due to the dividend component in ETF and the indirect costs you miss out in ETFs.

Other useful links to use:

1. Fund-wise rolling return metrics
2. MF Review tool
3. Best Mutual funds
4. Prime MF Ratings
5. Other useful articles on MF basics