Exchange-traded funds (ETFs) have been in focus of late, thanks to the Centre using the ETF route to divest holdings in public sector enterprises. The recent launch of Bharat 22 ETF was a big success, garnering around ₹14,500 crore for the Centre.
While ETFs have gained popularity globally due to their low fee structure, in India, retail investors have not really taken to passive investing through this method. There are 67 ETFs in India, with assets under management (AUM) of ₹85,044 crore ($12 billion) as on November 2017. This is a very small number when compared to the AUM of actively managed equity funds in India (₹7.1 lakh crore, or $110 billion) and that of ETFs globally ($4 trillion).
What are ETFs?
ETFs are passive funds where the fund manager simply tracks an index and attempts to accurately reflect its performance. They are mutual funds that are listed and traded on stock exchanges like shares. This enables investors to buy and sell units at prevailing market prices on a real-time basis during market hours.
There are four types of ETFs available in India: equity, debt, commodity and overseas equity.
Equity ETFs commonly track the Nifty50, Nifty Next 50, Sensex 30, Nifty 100 and BSE 100, with select ones tracking mid-sized companies. Thematic ETFs mimic indices that reflect a particular theme or sector. For instance, the Reliance ETF Shariah BeES tracks the Nifty 50 Shariah.
Debt ETFs track liquid fund returns and returns on the 10-year government security. Under commodity, gold ETFs are a key category. Reliance ETF Hang Seng BeES and Motilal Oswal MoSt Shares NASDAQ-100 ETF track global benchmarks.
ETF mechanism
ETFs are a kind of 2.0 version of index mutual funds. They vary from normal mutual funds (MFs) in terms of their functionality, and the manner in which they are created, bought and sold. In MFs, investors pay cash to the fund house which, in turn, buys the securities and constitutes the fund. In the case of ETFs, the fund house appoints market-makers in the stock market to execute all the transactions on their behalf.
The market-makers, also called arbitrageurs or authorised participants, purchase a basket of shares, as specified by the fund house, for cash. The basket is then exchanged with the fund house for a set number of ETF units (creation). The authorised participants then fulfil the market demand by buy/sell orders.
Authorised participants act as arbitrageurs between the ETF and index to keep the former’s market price closer to its net asset value (NAV). For instance, if an ETF is trading at a discount to its NAV, then the authorised participants buy units from the stock market and sell the same to the asset management company (AMC). The arbitrage mechanism ensures that there is no significant premium or discount to the NAV.
Cost efficient
ETFs are cost efficient. Given that they are passively managed they charge a lower expense ratio.
In India, Nifty 50 and Sensex 30 ETFs charge annual expenses of 0.05-1 per cent of their NAV. But actively managed funds charge 2.5-3.25 per cent. Open-ended index funds levy 0.20-2 per cent a year.
Not a preferred choice
Despite low costs, retail investors and high net-worth individuals (HNI) have not really taken to ETFs. There are a number of reasons.
One, ETFs in India have mostly underperformed the actively managed funds. For instance, the actively managed large-cap equity funds delivered a compounded annualised returns of 9, 15 and 12 per cent for the three-, five- and seven-year time frames while the ETFs tracking the Nifty 50 index clocked returns of 7, 12 and 8 per cent, respectively. But in the US, the UK and Europe, ETFs generated returns similar or superior to actively managed funds. Active fund managers in the developed markets have found it increasingly difficult to beat the market due to an efficient and developed system.
Second, in India, investors are left with a limited choice of funds when it comes to ETFs. The diversification in terms of asset class, market cap and theme are also limited. In the commodity space, only the gold category is available. On the equity side, though there are ETFs with themes such as central public sector enterprise (CPSE), Shariah, dividend yield, consumption and infrastructure, they are unable to attract investors due to a lack of awareness and tepid performance. The government’s divestment programme is also limited to CPSEs.
Also, though the ETFs in India are more cost-efficient than actively managed funds, they are a little costlier than global ETFs. Broker costs and demat charges add to the expenses. Investors’ awareness about ETFs is low. Given their low margin structure, mutual fund distributors prefer not to promote ETFs. This has led to reduced liquidity in the secondary markets, resulting in less efficient price discovery and higher spreads for investors.
Last, the efficacy of ETFs is measured through the tracking error, which measures how closely an ETF tracks its chosen index. A higher tracking error represents inefficiency, which could be an outcome of higher expenses, higher cash balance, corporate action and inefficiency of the market makers. Tracking error is high in many ETFs in India.
Suitability
ETFs help investors avoid the risk of poor stock selection by the fund manager. Further, stocks in the indices are carefully selected by index providers and are rebalanced periodically.
So, if you are a newbie to the equity market, then ETFs tracking indices such as Nifty 50 index or Sensex can help you start your investment portfolio, without making complicated choices from among fund houses and fund managers.
ETFs are also suitable for investors who want returns in line with the market, with limited risks.
Retail investors who want to take advantage of special issues such as CPSE and Bharat 22 can invest in ETFs. The additional discount for retail investors is another advantage.