When it comes to mutual fund investments, wouldn’t you find it beneficial if they could be conveniently traded on stock exchanges like stocks? ETF investments combine these two features and help you consistently grow your earnings over time. To make your ETF investments more efficient, a key factor that you must consider before investing in an ETF is the ETF expense ratio.
How do ETFs work, and what are the types of ETF?
Here is a summary of how exchange-traded funds work. They are a collection of investments that help you invest in multiple securities all at once. They generally charge lower fees when compared to certain categories of mutual funds. A characteristic feature of ETFs is that they can easily be bought and sold during a trading day. The ETF provider builds a basket of assets (including stocks, bonds, commodities, currencies, etc.) and helps investors buy a share in that basket the same way they would buy stock in a firm.
What is an ETF expense ratio and how does it work?
An ETF’s expense ratio is a representation of the amount it costs to operate the ETF. ETF expense ratios are generally represented as a percentage of the fund’s average net assets and can include several operational costs and fees depending on the fund house offering the ETF. For instance, if you invest ₹1,00,000 in an ETF with an expense ratio of 0.4%, you must pay ₹400 to the fund house for the ETF’s management. An ETF expense ratio can include the following expenses –
- Administrative fees
- Compliance fees
- Management fees
- Marketing fees
- Record-keeping fees
- Auditing fees
- Legal fees
- Shareholder service fees
These expenses also impact the NAV (net asset value) of the ETF. An ETF’s NAV is the per-share value of the exchange-traded fund’s assets minus any liabilities such as operating expenses. This fee does not include brokerage commissions, transaction fees, and other fees to financial intermediaries that you may pay for the purchase and sales of ETF shares on secondary markets.
Certain characteristics of an ETF expense ratio that you must know
You must know the different types of ETF expense ratios and their characteristics before making an ETF investment:
- Generally, the ETF expense ratios of ETFs that invest in foreign securities are higher than those that invest in Indian treasury bonds or gold.
- As the assets of an ETF increase, its fixed costs represent a smaller percentage of its net assets. This translates to a reduction in the ETF’s expense ratio.
- If you invest in an actively managed ETF, you might have to bear higher expense ratios when compared to passively managed ETFs.
Points to consider while investing in an ETF scheme
- Define your investment objectives: You must fix your investment objectives before you invest in an ETF scheme. Doing so will help you consistently grow your income and choose the right investment amount.
- Choose an ETF with a lower ETF expense ratio: Next, you must assess the ETF expense ratio of the ETF and compare it to other ETF (preferably with lower ETF expense ratios) schemes to avail all ETF benefits.
- Always have limit orders in place: It is advisable for you to place limit orders while trading ETFs. You must do this especially while trading ETFs that have a low trading volume as executing market orders can result in transactions taking place at significantly higher or lower prices than anticipated.
- Always track the volatility of ETF prices in the market: Multiple factors affect the volatility of ETF prices in the market, including reduced trading volume, market volatility, and order imbalances. You must regularly track the volatility of ETF prices to avoid paying a higher amount while buying an ETF.
You should analyse and compare the ETF expense ratios charged by various funds before investing in an ETF scheme. An ETF expense ratio is the fee charged by the fund house in return for operating the ETF scheme.