Are ETFs the right investment option for you

Many famous fund managers in India and around the world consider themselves disciples of Warren Buffett. Some of our readers in Advisorkhoj may be Buffett fans; you should know that, Warren Buffett himself is a fan of Exchange Traded Funds (ETFs) and Index Funds. A few years back Buffett asked his heirs to put all his wealth in ETFs / index funds when they inherit his estate. We will discuss Buffett’s views on mutual funds, hedge funds and ETFs later in the article, but Buffett’s advice to his heirs should not come as surprise to people, who have been following Buffett over the years.

Unlike in the developed economies, Exchange Traded Funds (ETFs) still have not gained as much popularity among retail investors here in India, despite being around for 15 years. The popularity of mutual funds compared to ETFs and index funds can be attributed to structural difference of our market relative to the developed markets, but also in our opinion due to lack of awareness of ETFs among retail investors in India. While many investors do not know about ETFs, among the ones who are aware of ETFs, many are not clear how is ETF different from a mutual fund? What is the difference between an ETF and an index fund? In this blog post, we will discuss the basic characteristics of ETFs and compare them with other asset types.

Basic Characteristics of ETFs

ETF is an instrument which invests in the basket of securities that, reflects the composition of a market index, like Nifty, Sensex, Bank Nifty, CNX – 100, CNX – Midcap, Nifty - CPSE etc. Like mutual funds ETFs are managed by Asset Management Companies (AMCs). Below are the basic characteristics of ETFs

• ETFs combine the characteristics of shares and mutual funds. Investors can buy or sell units of ETFs, just like they can buy or sell units of mutual fund schemes. However, like publicly traded shares, ETFs can be bought or sold only in stock exchanges.


• To invest in an ETF, investors need to have a demat account and trading account.


• The price of an ETF unit is expressed in terms of Net Asset Value (NAV) like mutual funds. However, the price of an ETF unit changes on a real time basis during market hours, just like price of shares.


• As discussed earlier, ETFs aim to replicate an index. The ETF manager aims to track the index as closely as possible. The fund manager does not aim to beat the index.


• The cost of an ETF is much lower than actively managed funds. By cost, we do not mean the price or NAV, but rather the expense ratio.

Why Invest in ETFs?

ETFs give equity investors the opportunity to buy or sell an index. Since ETFs work on concept of pool of money like mutual funds, you can buy an index with a much smaller capital outlay. It is not possible to buy an index in the cash segment of the market. You can create a basket of stocks that replicates an index but it will require a big capital outlay. For example, if you want to create a basket of stocks that replicate Nifty, you will have to buy shares of 50 companies in amounts that will reflect their weights in the Nifty. Share prices of some Nifty stocks are more than Rs 20,000. Average share price of Nifty stocks is around Rs 1,900. If you want to create a basket of stocks that exactly replicates Nifty you will require a sufficiently large capital outlay running in several lakhs of rupees. On the other hand, you can invest any amount that you want, in buying Nifty ETFs from the market, based on their NAVs. Secondly, stock market indices like Nifty are market-value-weighted index and the relative weights of the underlying stocks change on a daily basis. So you have to buy and sell shares on a regular basis (daily) to exactly replicate the weights of the index.

Difference between ETFs and F&O

Some readers may argue that, investors can buy or sell an index in the Futures and Options (F&O) market, with a much lower capital outlay compared to a basket of stocks. Given current lot sizes in the NSE and margin requirements, minimum capital outlay in ETFs will still be much lower compared to futures.

Investors should also know that, futures and options have expiry dates (last Thursday). ETFs have no expiry date. You can buy and hold an ETF for as long as you want, once you have made your investment. F&O are trading products, whereas ETFs are investment products.

In F&O you can take a much bigger position with a smaller capital outlay. While your profits may be high, your losses can also be high. F&O positions are marked to market and in case of an adverse market movement investors may have to pay additional monies for margin even before expiry. Unlike F&O, ETFs are not leveraged positions and hence there is no margin in ETFs. If there is an adverse market movement, your ETF NAV will fall but you will not have to pay any additional money. Risk in ETF is therefore, much less than futures.

Difference between ETFs and Mutual Funds

ETFs are similar to mutual funds in some ways, but there are very significant differences, which investors should be aware of.

• You do not need a demat account to invest in mutual funds, but you need a demat account to invest in ETFs.


• 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 fund managers 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 and income generation 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


• You can invest in mutual funds through SIP, but you cannot invest in ETFs through SIP


• Even though some mutual funds may be listed on the exchange, the liquidity on the exchange is quite low. ETFs on the other hand, are more liquid in the market since institutional investors mostly participate in ETFs.


• As discussed earlier, the cost of ETF is much lower than mutual funds, since they are passively managed. Is the cost of ETF in India as low as the developed economies like the US? Securities transaction cost in India is certainly not low due to a variety of factors (please note that, securities transaction cost affects both ETFs and mutual funds). Why is securities transaction cost high in India, is a different topic which we will not go into; for the purposes of this post, it suffices to say that, expense ratio of ETFs is much lower than mutual funds.

Difference between ETFs and Index Funds

Many people use ETFs and index funds synonymously. While there are similarities between the two, there are differences between the two which investors should clearly understand. Index funds like ETFs invest in a basket of stocks which replicate the index. Index fund managers do not aim to beat the index; they simply want to reduce the tracking error. The investment objectives of index fund and ETFs are the same. The most important difference between index fund and ETF is that, index funds are mutual fund schemes. You do not need a demat account to invest in index funds. You can buy index funds from the AMC and redeem them with the AMC, like you do in mutual funds.

Cost wise (expense ratio), ETFs are cheaper than index funds. However, when comparing costs of ETFs and index funds, I have seen that, many experts and bloggers ignore the transactions costs. You should not just compare the expense ratios of ETFs and index funds. If you buy ETFs there is no securities transaction tax (STT), but if you sell then STT is applicable. You also have to pay brokerage. In addition to STT and brokerage, you also have to pay charges to the Depositary Participant for holding your ETFs in demat format.

In our view, even after factoring in all these costs, ETFs work out to be cheaper compared to index funds, but the difference is less than what you estimate simply by comparing expense ratios. While index funds may be more expensive than ETFs, they are certainly cheaper than diversified equity mutual funds.

Should you invest in ETFs?

Let us go back to where we began in this article. As mentioned at the start of this post, Warren Buffett is a big fan of ETFs / index funds and he advised his heirs to put his wealth in ETFs / index funds when they inherit the estate. Warren Buffett, for many years, has been of the view that, over a very long investment horizon fund managers cannot beat the market. Research in the US has shown that, diversified equity funds on an average have struggled to beat the S&P 500 (the broad based market index in the US) over a very long investment horizon. If fund managers are not able to beat the market, Buffett argues, why should we pay more for actively managed funds (higher expense ratio)? ETFs or index funds are better investment options in such a market.

Readers should note that, this is Buffett’s view of the US market and not necessarily Advisorkhoj’s view of the Indian market. In India, however, we have seen that, diversified equity funds have managed to beat the market (Nifty / Sensex) over a long investment horizon. Therefore, Buffett’s view is not necessarily applicable in India. This is primarily because our equity market is less mature than the US market or stock markets in other advanced economies. When a stock market matures, it becomes more efficient. Structural inefficiencies in the market can give rise to profitable opportunities which can be exploited by experienced and expert fund managers. Top performing diversified equity mutual fund schemes have managed to beat ETFs in performance across several time-scales. As our market matures, these inefficiencies will slowly go away, but it will take its own time. As of now and in the coming years, we believe that, good fund managers will be able to beat the benchmark and create alphas for the investor, just like Buffett himself did in the US.

ETFs can also help you make investments in specific investment themes e.g. banking, PSU banks, Central Public Sector Enterprises (CPSEs) etc, if you have sufficient knowledge about these themes. You can also invest in themes through thematic or sector mutual funds, but the number of such schemes for each specific theme is limited and again you have to be dependent on the stock selection ability of the fund manager of these schemes. If you have sufficient conviction in these themes, rather than conviction regarding the fund manager, then ETFs are also good investment options.

Conclusion

We are arguing neither for nor against mutual funds versus ETFs. Investors should know that, there is a big performance differential between top performers, average performers and bottom performers in the mutual fund space in India. High returns, over a sufficiently long investment horizon, are therefore contingent on investors identifying schemes managed by good fund managers.

A good financial advisor can help you identify such schemes, but if you do not want to be dependent on the fund manager’s ability to create alphas or your financial advisor’s ability to identify such schemes and believe that in the long run the market will become more efficient, then ETFs can be good investment options for you. In Advisorkhoj, we want to make our readers aware of different investment options available to them, so that they can make the best decision for their financial goals.

Disclaimer