Making ETF A Part Of Your Portfolio

Making ETF A Part Of Your Portfolio

Why do exchange traded funds (ETFs) suffer from low investor participation even when they have generated better returns than index funds in the same period? The following report provides insights into the ETFs and how they function while pointing out their merits and demerits in terms of retail investing 

September 2020 was the third month in a row when there was a net outflow from equity-dedicated mutual funds. During the same period, there were net inflows of more than Rs20,000 crore into exchange traded funds (ETFs) other than gold but including fixed income. The rise in asset under management (AUM) of ETFs has been even better. Healthy inflows along with gains in the equity market have led to increase in the AUM of ETFs. In fact, over the past two years ending September 2020, the AUM of ETFs has increased at an annual rate of 51 per cent.

The pace of growth of AUM in ETFs far exceeds the growth in AUM of equity mutual funds, which grew by a mere 6 per cent annually in the same period. There are a couple of reasons for ETFs to outpace growth in mutual funds. First, the base was small for the ETFs. At the end of June 2015, the total AUM under ETFs was merely Rs7,320 crore compared to the AUM of equity mutual funds of Rs3.7 lakh crore. Besides, institutional investors made a foray into ETFs only as late as in the year 2015. The acceleration in the growth of ETFs’ AUM began from 2015 when the Employees’ Provident Fund Organisation (EPFO) was allowed to take equity exposure. At present, the EPFO is only allowed to make equity investments through passively-managed ETFs.

The real pick-up in the AUM of ETFs therefore was observed only after this institution was allowed to invest. Besides, the government too started to offload its shares in state-owned enterprises through ETFs to meet the disinvestment target. Hence, from a mere 1 per cent of the total AUM of the domestic mutual fund industry, ETFs have now climbed up to almost 7 per cent of the total AUM. In terms of absolute growth they have grown 23 times in the last five years ending June 2020.

Low Participation of Retail Investors

However, despite such a growth curve, ETFs are yet to be embraced by retail investors. The penetration of ETFs still remains low among retail investors. At the end of June 2020 only 1.69 per cent of the total AUM was derived from retail investors while in terms of the number of folios, it accounted for 95.96 per cent. The share of AUM has come down from 9.95 per cent at the end of June 2015. The total AUM has slipped down in terms of percentage but has increased four times in absolute terms from Rs700 crore at the end of June 2015 to Rs3,000 crore at the end of June 2020.

Origin of ETF

Very few people would know that the origin of ETFs can be traced back to the report by Securities and Exchange Commission (SEC), a US’ market regulator. The report titled ‘The October 1987 Market Break’ was an investigation about the Dow Jones Industrial Average’s steep fall of 508 points or 22 per cent in a single day on October 19, 1987, which till date remains the single biggest fall in terms of percentage for DJIA and is now better known as ‘Black Monday’. This 840-page report by SEC diagnosed ‘portfolio insurance’ as the reason for such a fall, which inadvertently suggested the product idea of ETF.

The report recommended an alternative approach where a well-capitalised and supplementary market-maker could have turned to a single product for trading baskets of stocks, which would have made the fall less drastic and smaller. The idea was picked up by the product development team of American Stock Exchange (AMEX), and that led to the first ever ETF in the US. The Standard & Poor’s Depository Receipts (SPDR) focused on investing in the Standard & Poor’s (S & P) 500 index, which till date remains the largest ETF in terms of (AUM). And as said, the rest is history!

There are some specific reasons why ETFs have a lower presence in a retail investor’s portfolio. A typical retail investor will decide how to invest by consulting an independent financial adviser. ETFs are not promoted by many financial advisors or distributors as they have fewer incentives to do so. They will not earn any trailing commission out of the investment an investor makes in ETFs. Mutual fund distributors play a big role in bringing in investments from retail investors. According to the latest data by industry body Association of Mutual Funds in India (AMFI), these distributors raked in more than 80 per cent of the total AUM of individual assets and hence play an important role in promoting products such as ETFs among retail investors.

Besides, for an investor who is only investing in mutual fund schemes, there will be the additional burden of opening a trading and dematerialisation account and maintaining it, which comes at a cost. Therefore, many retail investors opt for index funds instead of ETFs. In addition to these technicalities, we believe that lack of understanding and awareness of the product is also a prime reason for lower acceptance of ETFs by retail investors. Hence, we will try to clear the air around this product. Before that, however, we will check if it is a good investment in terms of returns.

Performance Comparison

Most of the index funds and ETFs follow a passive investment strategy where they try to replicate an index. In India, most of the ETFs and index funds have Nifty 50 or BSE Sensex as the benchmark. They account for almost 50 per cent of total ETF assets. As such, we have compared the returns generated by ETFs, index funds and their benchmarks. In the figure below we have compared returns of 26 ETFs and index funds benchmarked against Nifty 50 TRI for the last one year.

We see that ETFs have generated better returns than index funds in the same period. One of the reasons for such a better performance is the lower expense ratio of ETFs compared to index funds. While the average expense ratio of ETF is around 0.25 per cent, for index funds it is around 0.75 per cent. Nonetheless, we have not added the extra cost of brokerage and dematerialisation (demat) charges, which is applicable only in ETFs and not to index funds. Other than brokerage, most of the expenses remain constant irrespective of the investment done in ETFs. Even if we add 0.5 per cent as extra expenses for brokerage, demat expenses, impact cost and other statutory taxes, ETFs have still outperformed index funds in the last one year. Therefore, return-wise we see that they are clearly in a winning position.

Traded but not Equity

Nonetheless, there are some other issues playing in the mind of an investor that may act as an obstacle to acceptance of ETFs. These issues crop up because most retail investors associate ETFs with shares that are traded on the exchanges. For example, there is misconception that the average daily trading volume of an ETF determines its liquidity. Similarly, the amount of ETF that can be traded is a function of the AUM of the ETF. You need to remember that the trading and market structure of ETFs share similar characteristics to stocks, but the way the units are issued and extinguished is very different and hence no similarity should be drawn with shares.

This can be better understood if we examine the working of ETFs and how are they issued and withdrawn. The units of ETFs are created when professional investors—known as ‘authorised participants’ or APs—place an order directly with the ETF manager. In exchange for payment, the AP receives ETF shares, which can then be sold by the AP in the secondary market. The AP can create more and more ETFs as per the demand, as is indicated in the image alongside.

Liquidity in ETFs

Liquidity in layman terms means how easily you can buy or sell a security without having much of impact and transaction cost. For example, if you have a security with higher liquidity, you can always sell or purchase quickly without incurring much of impact cost due to tight ‘bid-ask’ spreads. Better liquidity also protects a security from sharp price swings due to larger trade orders. Since both equity and ETFs are traded on a stock exchange, investors believe that the liquidity characteristics of both the securities are similar. Nonetheless, the earlier illustration clearly shows they are different. ETFs have some unique features that differentiate them from stocks when it comes to liquidity. They are fundamentally different from stocks and hence have a direct bearing on the liquidity of the ETFs.

Unlike stocks that have limited supply in a shorter period in the secondary market, ETFs do not suffer from this limitation. They are open-ended investments such as mutual funds and can be issued or withdrawn from the secondary market according to the supply or demand situation. Therefore, if there is demand for a particular ETF, it can be created and issued. The trading volume or AUM of an ETF alone cannot determine its liquidity. It is the underlying security which forms the ETFs and determines their final liquidity. For example, ICICI Prudential Sensex ETF, which had an AUM of rs32.6 crore at the end of September 2020 and barely trades, will not suffer from lower liquidity in case of higher demand of the ETF.

This is because the underlying securities that are Sensex constituents have enough liquidity to create the right amount of ETFs without much of impact cost. As on October 15, 2020, the bid-ask spread of this ETF on the BSE wasRs3 and the NAV of the ETF wasRs437, which means 0.4 per cent of the impact cost. Other ETFs such as Motilal Oswal Most Shares Nasdaq 100 ETF has a bid-ask difference in paisa and its NAV is at Rs858. Even in the case of debt ETFs such as Bharat Bond ETF, there is a negligible impact cost.



Nimesh Shah
Managing Director and CEO , ICICI Prudential AMC

The two most important drivers for ETF growth in India have been the government and regulatory thrust on this segment. The government thrust has been largely driven by EPFO corpus allocations and adoption of ETFs for its disinvestment initiatives. In addition, the focused approach of the mutual fund industry towards awareness creation, digital adoption and product innovation over the years covering simple products like Nifty or gold ETFs to ‘smart beta’ ETFs has helped the category gain popularity.

Therefore, we do not see liquidity as an issue while investing in ETFs until and unless there is a problem of liquidity in the underlying. Even in case of mid-cap-based ETFs we have seen that there is hardly any issue of liquidity impacting the cost of acquisition. Hence, the volume of ETF shares traded is not an accurate measure of the underlying liquidity of an ETF. ETF volumes tell you only what has traded, not what could be traded. To see what could be traded, an investor has to look through to the underlying stocks. Hence the liquidity of an ETF, be it a newly issued or established product, is always a function of the liquidity of the underlying assets.

As of October 15, 2020, the market fell by almost 3 per cent and despite that there was no crunch of liquidity or spike in the bid-ask spread of major ETFs. Therefore, you can be reasonably confident that when required you can successfully liquidate positions, even in times of stressful market conditions. Thus, the trading volume of the stock gives an indication of the liquidity. An ETF, on the other hand, is an open-ended fund that can issue more shares based on demand and can terminate shares based on redemptions. When there are more existing shareholders looking to sell than there are new investors looking to buy, market participants (APs) or market-makers would step in as buyers. The price at which those market participants would purchase the ETFs would be driven by the price at which they could sell the underlying basket of securities since they would most likely need to redeem shares.

Constructing an ETF Portfolio

The share of AUM by retail investors in overall ETFs has definitely declined in the last few years. However, if we go by the number of folios, there has been an exponential rise. The number of retail folios in ETFs has increased by almost 9.5 times for the five years ending June 2020. Most of this growth has come in the last one year only when the number of folios has increased by 13 lakhs. Currently, there are 21 lakh retail ETF folios.

This shows the underlying interest in the product and it can rise further at a faster pace if the investors are properly guided. ETFs provide liquid access to virtually every corner of the financial markets, allowing investors to make a well-diversified portfolio at lower cost. High levels of transparency for both holdings and the right investment strategy can help investors easily evaluate an ETF’s potential returns and risks on a real-time basis.

ETF Schemes

ETF is not limited only to equities. There are ETFs that have underlying debt instruments beside gold. Following are the main categories of ETFs available in India.

✓Equity: Based on equity indices like Nifty 50, Nifty Bank, S & P BSE Sensex, Nifty Mid-Cap, etc.

Debt: Based on indices like Nifty 8-13 years G-Sec index etc.

Gold: Based on gold prices and invests in gold bullion.

World Indices: Based on international indices like Hang Seng, Nasdaq 100, etc.

With this gamut of options available, we are sharing here a portfolio purely made out of ETFs that can be used by individuals. ETF selection is an important issue for investors. The tools developed in the case of active management are not suitable for evaluating the performance of these ETFs. The objective of an ETF is to offer an investment vehicle that presents a very low tracking error compared to its benchmark and also needs to have a lower expense ratio so that there is minimum leakage.

Therefore, we have selected funds giving equal weight to tracking error and expense ratio. The fund with the lowest combined score in its category is selected. This model portfolio is suitable for moderate risk-taking investors with investment horizon of minimum five years. Once you have invested in this fund you need to review it periodically and rebalance it annually. This will help you to optimise your return and risk level. 

INTERVIEW


Radhika Gupta
Managing Director and CEO, Edelweiss Asset Management Limited

Debt ETF is a large space still unexplored

How do you see the future of passive investment in general and ETFs in particular in India?

India has already woken up to the benefits of passive investing similar to that of the US in the Nineties. But India’s share of passive investments is still small compared to its domestic mutual fund industry, which has been demonstrating doubledigit growth for the past several years. However, EPFO’s steady investments into large-cap ETFs in recent years and the Government of India’s divestment programme via ETFs along with the launch of Bharat Bond ETFs have helped in the strong growth of passive AUM share. We strongly believe that such tailwinds will continue to aid the penetration of passive investments, more importantly ETFs, into the Indian markets. Debt ETF, in particular, is a large space still unexplored and can grow rapidly in the coming years.

What technical factors – as for example, liquidity – should an investor look for before investing in ETFs?

ETFs in India are predominantly based on broad indices, themes or a particular asset class like gold. A first-time investor in ETFs should initially select his preferred theme or asset class as per his risk appetite and asset allocation goals. Subsequently, he may focus on trading volumes, tracking error and expense ratio to zero in on a particular ETF. Higher trading volumes and lower tracking errors and expense ratios are considered to be the benchmarks of a quality ETF.

Why should a retail investor investing in index fund choose ETF?

There are favourable arguments for both, index funds and ETFs. The primary difference between an index fund and an ETF is that the former is a mutual fund and the latter, as its name suggests, is traded like a stock on the exchange. The price at which you buy an index fund is its NAV arrived at the end of the trading day. Unlike ETFs which trade like stocks, you are unable to take advantage of intra-day price movements in the case of an index fund.

On the other hand, an ETF with lower liquidity on exchange increases the impact cost while investing and in such cases an index fund is a better option. Moreover, investing in an index fund doesn’t require a dematerialisation account. Hence, we believe that if an investor is sure about liquidity in a particular ETF then he can invest via an ETF. Else, an index fund would be a better choice.

Where do you see ETFs and Smart Beta ETFs fitting into an investor’s portfolio?

Any investor chooses a product primarily based on the following five factors: risk, return, cost, liquidity and convenience of operation. ETFs and index funds are known to be low-cost, low-maintenance products which should feature in every retail investor’s portfolio as a complement to his investments in actively managed mutual funds. ETFs can be a good way to take market beta exposure. While diversified market capitalisation-based ETFs or index funds may form part of the core portfolio of an investor, thematic ETFs and index funds or Smart Beta ETFs may feature as satellite holdings.

From a retail investor’s perspective, where do you see Bharat Bond ETF fitting into his portfolio?

Bharat Bond ETF is a debt ETF investing in AAA-rated PSU bonds. It has a very unique combination of features such as transparency, low cost, sufficient liquidity with predictable and stable returns at a fixed maturity. It is a good choice for an investor who wants to supplement his debt portfolio with this fund. Given its unique features of target maturity and high quality, Bharat Bond ETFs can be a good fit for planning goal-based investments and can be a core part of an investor’s fixed income portfolio.

Disclaimer: Ms. Radhika Gupta is the MD & CEO of Edelweiss Asset Management Limited (EAML) and the views expressed above are her own. Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

Attributes of ETF Investors

So, does it mean an investor should replace mutual funds? Not at all! Though similar, both the products are structured differently and investors can use them judiciously to achieve their financial goals. ETFs can help you to build tailored, diversified, low-cost portfolios exclusively, or to complement an existing portfolio. ETF is a hybrid product that shares the characteristics of both mutual fund schemes and equity shares. Hence, it should not be considered as replacement for either of them. Mutual fund schemes offer certain benefits that do not automatically come to ETFs. For example, systematic investment plan (SIP), systematic withdrawal plan (SWP) and systematic transfer plan (STP) are specific to mutual funds.

Thus, if you are the type who saves every month to invest, mutual fund is still your best option. Investment through mutual fund schemes also offers you rupee cost averaging. ETF is more suited to investors who want to invest lump sum and is infrequent. Since there is a bid-ask spread while buying ETFs, these upfront costs can mean that an ETF might be more cost-effective for clients making large, infrequent contributions to their portfolios. ETFs are cheaper to maintain in terms of expense ratio and this makes them attractive as a long-term investment.

In the short term you may incur more expense towards commission and dematerialisation charges. Moreover, ETFs are suitable for those investors who have good knowledge of the equity market and want to use strategies that are associated with equities. In terms of portfolio positioning, a broad-based and market-based ETF can be part of your core portfolio while certain concurrent themes can be part of your satellite holdings.

 

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