Should you invest in Exchange Traded Funds

While awareness about exchange traded funds (ETFs) is quite low in India, these funds are gaining currency with investors over the last few years. In the last 5 years, the mutual fund industry assets under management (AUM) in ETFs have grown at a CAGR of more than 100%. In FY 2018 alone, the ETF AUM grew by more than 64% on a year on year basis. But ETF AUM still constitutes a fairly low percentage industry wide equity AUM in India – ETF AUM was only about 10% of industry wide equity AUM in FY 2018. In the developed markets, however, ETFs and index funds are hugely popular with investors. In this blog post, we will discuss about ETFs, so that investors can make informed decisions with regards to whether these funds can be suitable for their investment needs.

Exchange Traded Funds

Exchange traded funds are passive schemes, which aim to track a particular market index like Sensex, Nifty, BSE – 100, Nifty – 100 etc. ETFs invest in a basket of stocks which replicate the index ETF aims to track. ETFs do not aim to beat the index like actively managed mutual fund schemes; they aim to minimize the tracking error. Tracking error is difference in returns of the ETF and that of the index. When investing in ETF you should expect to get the index returns, nothing more and nothing less.

Differences between ETFs and actively managed MF schemes

• In mutual funds, the fund house acts as the counter party to the investor. Mutual fund investors do their buy / sell transactions with the fund house. ETFs are listed on stock exchanges like stocks. Investors can buy or sell ETFs in the secondary market (stock exchanges).


• Mutual fund net asset values (NAVs) are priced at the end of the day. ETF prices, like stock prices, change real time throughout the day based on demand and supply in the market.


• You can invest in mutual funds through mutual fund distributors (financial advisor), through Registrar and Transfer Agents (RTAs) or directly with Asset Management Companies (AMCs). In order to invest in ETFs you need to have a demat account with a stock broker.


• ETFs do not aim to beat the benchmark index; they aim to track the benchmark index.


• Since ETFs are passive funds, the expense ratios of ETFs are much lower than actively managed mutual fund schemes.

Advantages of ETFs versus actively management MFs

• Cost:

  The biggest advantage of ETFs over actively managed funds is cost. The expense ratio of ETFs can be 2.25 to 2.5% lower than actively managed funds. Actively managed funds need to beat their benchmark by 2.5% just to match returns of comparable ETFs. Top performing actively managed mutual funds have historically delivered high alphas to investors, but many average and below average performers struggle to beat the benchmark. If you are confident in your or your financial advisor’s ability to identify top performing funds which will do well in the future as well, then you can invest in actively managed funds, otherwise ETFs will be the better investment option for you. Over long investment tenors the cost advantage of ETFs versus actively managed funds, can be of significant advantage to investors.



• Unsystematic Risk:

  Equity investments are subject to two kinds of risk – Systematic risk and Unsystematic risks. Systematic Risk or market risk is unavoidable because equity as an asset class is volatile. Both ETFs and actively managed funds are subject to market risks. Unsystematic risk is company specific risk or sector specific risk. Though mutual funds aim to reduce unsystematic risk by diversifying across stocks and sectors, they will have some residual unsystematic risks because actively managed funds will be over-weight on certain stocks and sectors versus the index. ETFs do not have any unsystematic risk because they simply track the index. If you want to totally avoid unsystematic risk and only take market risk, then ETF is the better investment option for you.



• Simplicity:

  Investing in ETF is much simpler than investing in actively managed funds. You do not have to analyze past performance, understand the fund manager’s investment style e.g. growth, value, GARP, study fund’s performance in up and down markets etc. Most ETFs track the large cap indices like Nifty, Sensex, BSE – 100, Nifty 100, Nifty Next 50 etc. These are the most dominant indices in the market – the Nifty 100 index represents 75% of free float market capitalization of all stocks listed on NSE. Simply select an index and invest in a low cost ETF, which tracks that index.

Disadvantages of ETFs versus actively managed funds

• Alpha:

  As discussed earlier, actively managed funds aim to beat the market benchmark. Historically, top performing actively managed diversified equity funds were able to deliver alphas over long investment tenors and create wealth for investors. Returns of top performing actively managed funds are usually higher than ETFs over long investment tenors in India.



• Thematic:

  Actively managed funds can help you can invest in themes, which you think will outperform the broader market in the long term. Thematic investment is risky because they can underperform for long periods of time, if the theme does not play out in the way the fund manager envisaged. On the other hand, investing in themes which have higher growth potential can also generate superior returns for investors.

Want to invest in an index at low cost but do not have demat account

The hassle of opening a demat account with a stock broker puts off many investors who may have wanted to invest in ETFs. Fortunately, mutual funds offer “ETF like” investment products where you can invest in a passive fund which tracks an index, without having a demat account. Index funds are mutual fund schemes which aim to track a particular index like Sensex, Nifty, BSE – 100, Nifty 100, Bank Nifty etc. The fundamental attributes of index funds are exactly like ETFs, while the investment process (buying and redemption) is just like any other mutual fund scheme. The expense ratios of index funds are slightly higher than ETFs but much lower than actively managed funds – expense ratios of index funds can be 2 – 2.25% lower than actively managed funds. As such, index funds are excellent investment options for investors, who want to remain invested for long periods of time, but do not have the time or effort to monitor fund performance on a regular basis.

Advisorkhoj take on ETFs and index funds

A few years back, the legendary investor, Warren Buffett advised his own family to put his wealth in index funds after he is gone – such is his conviction that index funds will beat actively managed funds in the long term. His belief is not without basis – more than 90% of large cap companies in the US failed to beat the S&P 500 index over long investment tenor. There is also a theoretical foundation for Buffett’s belief – the Efficient Market Hypothesis.

In an efficient market all publicly available information is already factored in share prices. The corollary of this hypothesis is that if all information is priced in, then one investor does not have an edge over another investor. Market is a collection of all investors and therefore, extending the Efficient Market Hypothesis, it is not possible for an actively managed fund to beat the market. In 2007, Warren Buffett announced a $1 million bet that in 10 years S&P 500 index funds will beat actively managed funds. In December 2017, Buffett won the bet.

Assuming the validity of Efficient Market Hypothesis, Buffett’s bet shows that the US stock market is highly efficient, but can the same be said about our market? Refer to our tool, Mutual Fund Category Monitor. You will see that average actively managed mutual funds were able to beat both average index funds and ETFs over the last 10 years. This shows that there are pricing inefficiencies in our market, which fund managers are able to exploit and generate alphas for investors. There were major reforms in our stock market in the late 90s and 2000s, aimed at correcting structural deficiencies and making our market efficient. However, compared to markets in the US and other developed economies, our market is far from being efficient - fund managers in India can continue to generate alphas for investors in the future as well. As our market becomes more and more efficient, the alpha generating opportunities will narrow.

If you look at the last 1 year, index funds have beaten most equity mutual fund categories. This may simply be due to market conditions which favored large cap, but the interesting point here is that index funds were able to beat large cap equity mutual funds. In the long term, the performance differential between actively managed funds and index funds will narrow. Like in the US now, index funds will become very popular in India in the future.

Conclusion

In this blog post, we discussed about Exchange Traded Funds (ETFs) and Index Funds. These are excellent investment options for passive investors, who want to beat inflation and get good returns over a long investment horizon. Actively managed funds will continue to form the major part of investment portfolios, but ETFs and index funds will gain an increasing share of wallet over time. There are pros and cons of investing in ETFs and index funds, which we have discussed in this post. Investors should educate themselves about ETFs and index funds, so that they can take informed investment decisions.