I have been trying to understand the options available for the index based investments that include index based mutual funds or exchange traded funds. In principle, I am fan of exchange traded funds because (a) they follow a given index; (b) no manager involvement; and (c) low cost structure. Index based fund investments are very good vehicle if an individual wants to avoid stock selection and just wants to follow the index performance. In general, for last 10 years, the NIFTY index has returned an average of 15.5% per year. This return excludes the dividend payments.

The objective for my investment in ETF index fund is to follow the index performance. It will also act as a benchmark for my long term investments. I invest in individual stocks for long term wealth generation hoping to exceed the market performance. At a very minimum level, I would like my long term portfolio to beat the market by some percentage points. If I cannot do that, then it would make sense for me to close my long term portfolio, and invest all my money in index funds.

The focus today is about selection of a specific ETF based index fund. While selected any fund, the few aspects that investors should look into are (1) Expense Ratio; (2) Tracking Error; (3) Trading Volume.

There are two ETFs based on NIFTY index that I looked into viz. (1) NIFTYBeES; and (2) QNIFTY.

Expense ratio is the expenses incurred by the fund management to run the fund. It may include employee salaries, transaction expenses, administration expenses, marketing expenses, etc. The expense ratio for NIFTYBeES is capped at a maximum of 0.5% funds net asset values. The expense ratio for QNIFTY is 0.75%. So when both funds are essentially doing the same work, i.e. same objective of tracking the index, QNIFTY fund managers want to use more money.

Tracking error is a measure of how closely the fund tracks the index to which it is benchmarked (or the index). In an ideal case, at a maximum, the tracking error should be somewhat equal to the funds operating expenses. But there are no ideal scenarios in real life. The factors that cause such tracking errors are (a) execution; (b) cash holdings; and/or (c) dividends. I compared NIFTYBeES and QNIFTY performance with the index itself to determine the tracking error.

• Chart 1 shows the tracking error for NIFTYBeES as a percentage. On most days, the error is concentrated around +/-2%. In my view, this is a significant tracking error. Most of the time the fund is trading in positive 2% range which indicates a premium to actual index.
• Chart 2 shows tracking error for QNIFTY as a percentage. This fund was introduced in mid 2008 and hence does not have longer history. The error is all over the place with a range of +/-4%. However, lately, most of the errors is in -1% range, indicating discount to the actual index.
• Chart 3 shows the superimposed plots for NIFTY index, NIFTYBeES, and QNIFTY. It shows that the overall trend is very close to the index.

ETF Comparison Error Plots

ETF Comparison Value Plot

Trading volume means the total number of shares traded in a given timeframe. It is related to the liquidity of the funds. The higher volume of trades means there is more liquidity and more competition. It tends to reduce volatility. In addition, it also helps our ability to sell when we want to close our positions.

• Chart 4 shows trading volume for NIFTY index. Since October 2008, the trading volume is averaging around 300 million shares.
• Chart 5 shows the trading volume for NIFTYBeES ETF, Since October 2008, the trading volume is averaging around 180K shares.
• The trading volume for QNIFTY is so small that I could not plot on the same scale. The volume is in the order of 150 shares only. This say there is practically no liquidity for QNIFTY ETF fund.
  

ETF Comparison Trading Volume

To summarize….

Now that I have looked at both the funds, it tells us some story. QNIFTY is basically a crap fund. It has higher expenses, and it has practically no liquidity. So if an individual buys shares of QNIFTY, they will find it hard to sell it. Unless its asset size increases and/or reduce its expenses, I do not find this a good prospect. If QNIFTY fund managers cannot increase its asset size, I won’t be surprised if this fund is closed and wound up, or merged to some other funds.

NIFTYBeES exchange traded fund has relatively higher liquidity and lower expenses. But I am little bit concerned about its tracking error. I plan on long term investment and expect to invest only once a quarter. Therefore, I expect the error will have a minimal effect on my total returns. I have initiated a starter position in NIFTYBeES. This will allow me to follow it. In the next post, I will discuss the strategy that I plan on using to make regular investments.