ETFs aren’t the best for Indian investors

August 18, 2015 . Bhavana Acharya

If you kept up with the news lately, you know that the Employee Provident Fund Organisation will invest in the equity market through Exchange Traded Funds (ETFs). There is also the advice doing the rounds that, for risk-averse investors, ETFs are a great way to participate in the stock markets.

Theoretically, this advice is true. For investors in the Indian stock market, though, an ETF is not a good fit. One, given the wide array of stocks available outside the basic indices, it’s possible to get returns that are higher without taking on too much more risk. Two, the choice of ETF products is narrow. Three, the indices themselves are designed keeping liquidity criteria in mind more than any other factor.

An ETF’s merits

An ETF is based on a stock market or debt market index, or a commodity. An ETF’s portfolio exactly mimics the securities in its underlying index, in the same weightage. As and when the composition of the index is changed, the ETF will incorporate it in its own portfolio.

An ETF’s returns are thus almost exactly in line with the index. This is one reason why ETFs are suggested – in funds that actively switch around portfolio composition as the fund manager sees fit, you run the risk of returns falling short of the market. For the novice investor, there’s no need to study, understand and judge fund performance either.

The second reason is that expenses are low in an ETF. There is no fund manager fee for one, as the fund only requires tracking the index’s changes. For another, the limited churn of the portfolio keeps expenses down. Indian ETFs have an average expense ratio of less than 1 per cent. Actively managed funds have much higher ratios of between 2 to 3 per cent.

ETFs are traded on the exchanges and you need a demat account to invest or sell it. This apart, mutual funds have schemes called index funds that are akin to ETFs. The only difference is that an index fund is not traded, and you invest in it just as you would with any other fund scheme.

Limited choice

Globally, the ETF commands immense popularity; the NYSE alone has 1,262 ETFs listed on it as of June this year, up from the 1,176 last June.

Compare that to the grand figure of 39 ETFs listed on the NSE. More, the underlying indices or commodities of these ETFs are limited. Of the NSE-listed ETFs, over a third are gold. The Nifty index is the next most popular with 9 ETFs based on it. The handful left is spread across banks, public sector enterprises, liquid bonds, and some thematic indices. Index funds too are concentrated on the Nifty index or gold. This lack of a variety in products to choose from is a huge limitation in the Indian ETF market.

Next, buying the Nifty does not mean that you hold companies or sectors with good long-term growth prospects. Yes, the Nifty (and the Sensex) represents the market mood, but it does so by simply capturing stocks with the most liquidity; stocks’ impact cost and free-float market capitalisations are the primary selection criteria. The indices, including others such as the Nifty Junior or BSE 500, do not take into consideration revenue growth, profitability, management quality, or business prospects.

The NSE and BSE do have indices along strategic and sector lines such as dividend, manufacturing, consumption, volatility, and so on. But barring a couple such as Reliance AMC’s ETFs based on the Dividend Opportunities or NV20, or Motilal Oswal and Goldman Sachs’ funds on the Nasdaq and Hang Seng, none have ETFs or index funds with such indices as their benchmark. These strategic indices are also new.

Global ETFs, on the other hand, have a wide variety of themes and indices to play on – emerging market groups, country-wise markets, currencies, several strategic indices, sector indices, market capitalisation-based indices, treasury bonds, and so on.

Further, because ETFs are traded on the market, your return will be that captured by the ETF’s market price movement. And due to the vagaries of liquidity and trading, the market return may be lower or higher than the fund’s NAV return. We will address this point in detail in a separate post later.

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Besides, the sheer number of sectors and stocks outside the two bellwethers, or even the CNX 100, means that funds have good chances of snagging outperforming stocks. Sample this: the average market price return on ETFs based on the Nifty stood at 9.2, 16.8, and 9.7 per cent for the one, three and five year periods (see table). Moderate risk diversified large-cap funds, in comparison, returned 18.8, 21.1, and 11.6 per cent in the same timeframes.

True, large-cap funds don’t always stick to blue-chips and include riskier stocks. But even those that take on only moderate levels of risk have managed to comfortably outpace the market on a consistent basis across market cycles. Of course, fund selection is important here, but it’s well worth the effort as the level of outperformance is higher.

In a nutshell, ETFs are good when you want to invest in gold or global markets. But for your core portfolio, they are not a good fit.


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