Exchange Traded Funds: A largely unexplored investment option

Exchange Traded Funds (ETFs) have been around in India for the last 13 years. However, ETFs have not gained as much popularity in our country, as they have in more developed markets. The commission structure may have something to do with the lack of popularity of ETFs in India, something that the industry should collectively think about. Its lack of popularity, notwithstanding, ETFs on account of its characteristics merit an important consideration in the spectrum of investment products. What are Exchange Traded Funds (ETFs)? Exchange Traded Funds (ETFs) are essentially Index Funds that are listed and traded on exchanges like stocks. There are various categories of ETFs in India. They are:-

• Equity


• Gold


• World Indices


• Debt

An ETF is a basket of stocks that reflects the composition of an Index, like the Sensex or the Nifty. The price of the ETF reflects the net asset value of the basket of stocks. In many ways, it is similar to a mutual fund. However, mutual funds and ETFs differ in many ways:-

• Unlike a mutual fund, where NAV is calculated at the end of the day, the price of the ETF changes real time throughout the day, based on the actual share prices of the underlying stocks at any point of time during the day


• Mutual funds are actively managed, whereas ETFs are passively managed. Mutual funds aim to generate an alpha (or outperformance versus a market benchmark), whereas ETFs aim to track a particular index


• Mutual funds have specific investment objectives, like capital appreciation, income generation, large cap stock focus, midcap stock focus, sector focus etc. ETFs only aim to track the relevant index and reduce tracking errors


• Even though mutual funds aim to diversify unsystematic risks (or security specific risk), and they do diversify, to a large extent, there is likely to be still some residual unsystematic risk in mutual funds because mutual funds do not exactly reflect the market portfolio. ETFs, on the other hand, are only subject to systematic risk (or market risk), since they reflect the market portfolio

Why should an investor choose an ETF versus a mutual fund?

• In our blog, we have always advocated mutual funds as the ideal investment option for long term financial objectives. However, we had also cautioned investors that, not all mutual funds are equal. There are a large number of mutual funds and considerable performance differential exist between the funds in the top quartiles and the bottom quartiles. Please read our article, Choose Best Mutual Funds wisely: A big performance differential between top and bottom performers. It is not always easy to identify funds that will perform well in the future. One should not go with short term performance, when selecting a mutual fund (please read our article Do not go by short term performance when selecting a mutual fund). There are a number of factors that play an important role in determining future performance, e.g. fund manager track record, AMC track record, long term performance etc. It takes considerable skills and experience to identify a top fund that may outperform its peers and the market in the future. An ETF, on the other hand, tracks the market. There is little or no scope of outperformance or underperformance. If you just want market returns for your investment, which by no means have been unimpressive, given the equity market performance in India over the last 15 to 20 years, ETFs are very efficient investment options


• The alpha generated by the fund manager in a mutual fund, is to large extent dependent on the inefficiencies in the market. A good fund manager is able to spot these inefficiencies in the valuation of specific stocks or sectors, and is therefore able to earn higher returns. As our equity market matures, the inefficiency in the market will gradually reduce. Having said that, our equity market today is far off from being efficient. However, there are certain segments in the market that are more efficient than others. For example, the segment of the large cap stocks is more efficient than the midcap and the small cap segment. Given the proliferation of large cap oriented funds in the universe of equity mutual funds, and also FII preference for large cap stocks, the valuation inefficiency in the large cap stocks segment is lower and is further going to reduce over time. Hence, in this segment, ETFs will become an attractive investment choice. In fact, most of the equity ETFs in our market is in the large cap segment


• The expense ratio of ETFs funds is much lower than their mutual fund counterparts. The expense ratios of ETFs can be as low as 0.25%, whereas the expense ratios of mutual funds are in the range of 1.5% - 2.5%. Unless the mutual funds are able to generate considerable alpha in the long term, they will not be able beating the returns of ETFs in the long term


• Some people argue that performance is not the focus of the ETFs, since they only track the relevant indices. This is not entirely true. Why? The indices, which by their method of construction based on market capitalization, eliminate or at least, reduce the weight of underperformers in the index portfolio. Therefore, by extension ETFs also eliminate or at least reduce the weight of underperformers in their portfolio

What are disadvantages of investing in ETFs?

• You will only get market returns in ETFs. Top performing mutual funds have generated good alphas, over the short, medium and long terms. Therefore, by investing in ETFs you will be giving up alphas (or returns above the market benchmark) which top performing mutual funds can give you. Whether you have top performing mutual funds in your portfolio or are the funds in your portfolio generating alphas, is another question, that you need to evaluate yourself


• Even though an ETF is supposed to track an index, it may not be able to guarantee the returns of the index. While variations tend to be small, the difference between a fund’s return and the index’s return, often called tracking error, can sometimes be significant. When evaluating ETFs, you should keep an eye on tracking errors.


• As discussed earlier, the market of equity ETFs is not well developed in India. Most of the ETFs in India are focused on frontline indices or large cap stocks. There are not too many options in midcap stocks, sector specific stocks or debt investments space. However, of the few midcap and sector specific ETFs, that are available, the Motilal Oswal, MOSt Shares Midcap 100 ETF and the Goldman Sachs, GS Infra BeES fund have given excellent returns over the past one year or so.

Top performing ETFs

The table below shows the top performing equity oriented ETFs, along with the last 1 month, 3 months, 6 months, 1 year, 2 years and 3 years trailing returns. Please note that the 2 years and 3 years trailing returns are annualized. NAVs are as on close of trading session on, June 30 2014.

Conclusion

In this article, we have discussed the relative merits and demerits of exchange traded funds. ETFs cannot replace mutual funds in your investment portfolio. Yet, there are a number of reasons, as discussed in this article, why you may want to consider ETFs to complement your mutual funds portfolio, for the diversification of your overall investment portfolio. If your financial adviser deals in ETFs, you should consult with him or her, if ETFs are suitable for your investment portfolio. Even if your financial adviser does not deal in ETFs, you should consider allocating a portion of your long term investment portfolio to ETFs.