Q&A: To choose an ETF, look at tracking error and fees

Q&A: To choose an ETF, look at tracking error and fees

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Photo: iStockphoto

Photo: iStockphoto

I have an equity-linked savings scheme (ELSS), three large-cap funds and one liquid fund. I want to invest in an exchange-traded fund (ETF). How do I choose one?

—Siddharth Bisht

Typically, one aims to diversify through asset classes, market segments and market sectors. But one can also diversify by having managed an index fund. In managed funds, a fund manager determines where to invest and when. In index funds, the decision is made automatically by following a preset index (such as Nifty or Sensex). Investing in such funds is typically done through ETFs.

It provides risk mitigation by lowering fund-management risk. In the Indian context, going by the performance of ETFs compared to managed funds, fund management risk is a lesser risk to worry about.

You need to diversify your portfolio across market segments and categories before thinking of ETFs. Investing in three large-cap funds is an overkill for that segment, and ETFs can be effectively used in the category. So, replace one of your large-cap funds with an index-tracking ETF such as UTI Nifty Index fund. Also, replace another large-cap fund with a good mid-cap fund such as Invesco India Mid-cap.

To choose an ETF, you can look at tracking error (the difference between the performance of the underlying index and that of the ETF) and fund management fees.

Should a 75-year-old invest in monthly income plans (MIPs)?

—Girish Karmakar

MIPs are nothing but a variety of mutual funds belonging to the category of debt-oriented hybrid funds. They invest predominantly in debt instruments with about 10-20% exposure to the stock market. There is nothing unique about them in terms of their ability to generate regular monthly income (despite the name). So, regardless of the investor’s age, these funds cannot be relied upon for regular income generation.

For an elderly person, there are better, safer ways of using mutual funds for monthly income. They can take a portion (say 20%) of their investments in fixed deposits and invest in a portfolio of debt funds. Once invested, they can use systematic withdrawal plan to generate a fixed monthly cash flow from the portfolio. When the portfolio dries out in time, another tranche of money from FDs can be shifted here and so on. Using this method, the investor would be able to control the risk of investments while generating a predictable, tax-effective monthly cash flow.

Srikanth Meenakshi is co-founder and chief operating officer, FundsIndia.com

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