Should You Invest Onto Exchange Traded Funds?

ETF’s (Exchange Traded Funds) are catching the fancy of investors. Prima Facie, they seem to be on a tearaway growth path – in the past three years, their AUM (Assets Under Management) has risen five-fold - from 12,013 Crores at the end of September 2014 to 60,314 Crores in September 2017. In the same period, the total industry assets have just over doubled.

Earlier this year, Reliance Mutual Funds CPSE ETF’s FFO (Further Fund Offer) generated quite a frenzy; clocking Rs. 13,726 Crores in subscriptions – three times the base issue size of Rs. 4,500 Crores.

However, a closer look at the figures published by the Association of Mutual Funds in India (AMFI) throws up an interesting paradox. In the same three-year period between 2014 and 2017 that the collective ETF AUM grew by over 400%, the rise in the number of folios has been disproportionately low - rising just 28% from 6.96 Lakhs to 8.91 Lakhs. 

“After a sharp increase in the last financial year on the back of ETFs offered by the government as part of its disinvestment program, their folio count has actually shrunk marginally in the first half of this financial year; and currently account for less than 1% of industry folios”, points out Rajiv Shastri, ED & CEO, Essel Mutual Fund.

How should you, as an investor, interpret these seemingly contradictory ETF trends? And more importantly – do ETF’s warrant a place in your portfolio at this point? Let’s find out.

ETF’s - in a nutshell

An ETF is similar to an index fund, in the sense that it tracks a fixed basket of securities that is specified in the scheme’s mandate. Both Index Funds & ETF’s are popular among investors who are averse to taking on ‘fund manager risk’, or the risk that your fund manager’s calls will go wrong, thereby resulting in underperformance. 

The key difference between an index fund and an ETF is that the units of the latter are listed on stock exchanges, and can be bought and sold intraday, in real time. For this reason, you’ll need a demat account to invest into ETF’s. The T+2 settlement cycle for ETF units is exactly the same as it is for stocks. Dividends, as and when received from the underlying index constituents, are reinvested back in sync with the scheme’s investment objective, thereby boosting its NAV (Net Asset Value).

What’s driving them?

According to Sundeep Sikka, ED & CEO, Reliance Mutual Fund, there are three main factors driving the steep rise in ETF assets. The first, he points out, is the fact that the Government has been using ETF’s to fuel its ambitious disinvestment program. The cumulative target for the current fiscal is Rs. 72,500 Crores; of which Rs. 46,500 is aimed to be raised from the disinvestment of CPSE companies. 

The second, he notes, is the Government’s landmark decision to allow provident funds to invest into equities as an asset class, via the ETF route. Notably, the 10 Lakh Crore EPFO raised its equity investment ceiling limit from 10% to 15% earlier this fiscal, creating an immediate 22,500 Crore window of opportunity for ETF’s. 

The third, Sikka believes, is the fact the ability of fund managers to consistently generate outperformance or ‘alpha’ is diminishing, as a result of increasing competition and efficiency. “As more and more money flows into financial assets, portfolio managers will find it increasingly challenging to beat the markets”, he predicts.

Advantages of ETF’s

From a structural standpoint, ETF’s do offer some advantages over traditional mutual fund schemes. The most important one being their significantly lower expense ratios, compared to their counterparts. Since ETF’s are passive, there’s no need for ‘fund management’ per se, and this brings down associated costs heavily. For instance, SBI – ETF NIFTY 50 has an expense ratio of just 0.07%, compared to SBI Bluechip Fund, which has an expense ratio of 1.97%. Notably, the former is up 31.77%% in the past year, compared to the latter, which is up 29.46% in the same period^.

Renu Maheshwari, a SEBI Registered Investment Adviser & Co-founder at Finscholarz, believes that ETF’s tend to outperform managed funds during secular bull markets – defined as broad-based rallies that are disconnected from company fundamentals. “In a secular bull run, with low cost of fund management and almost negligible alpha in diversified funds, ETFs should be a primary choice of investment for the masses”, she advises.

Sikka also points out that traditional mutual fund schemes ironically end up penalising genuine long-term investors for the irresponsible behaviour of short term investors who flit in and out of schemes, since expenses are shared in a common pool.  “This does not happen in a ETF. A short-term trader incurs his trading, brokerage and other costs; while a long-term investor who stays put does not get penalised”, he notes.

ETF-Specific Risks

Shastri is of the viewpoint that the forced passivity associated with ETF’s can actually make them riskier in volatile markets. 

“As opposed to actively managed funds, where a fund manager can take steps to shield a portfolio from market volatility, ETFs are always fully invested in the exact composition of the index they replicate. As such, they will be exposed to the full brunt of any market correction that happens, a possibility that may catch some investors unawares”, he says.

Liquidity Risks exist too. If your ETF isn’t liquid enough on the day that you require your units to be enchased, you may end up taking a hit. This is how it works – the larger the volume of units you order to liquidate, the higher the ‘impact cost’ associated with the sale. Put simply, you could end up selling blocks of units at progressively lower prices than the previous block, bringing down your overall unit sale price.

Maheshwari echoes this viewpoint, warning us that “In India, where financial literacy is low; liquidity for investment vehicles such as ETF’s will always be a major concern”

Additionally, there’s also the risk of your portfolio underperforming during stock-pickers’ markets that are less ‘tearaway’ and more ‘deft-touch’ in nature. In immature markets such as ours, where inefficiencies regularly result in stock-picking opportunities, this remains a legitimate possibility.

Bottom line – should you bite?

As with most investment decisions, there’s no black or white answer to whether you should invest in ETF’s or not. Your decision needs to be made in light of your unique objectives and preferences. Each ETF has its own risk profile – for instance, a CPSE ETF that invests in stocks of just 10 companies and has a high sectoral concentration, will carry a much higher risk than an ETF that replicates the NIFTY index. If low expenses, exchange tradability, and the negation of fund-manager-specific risks are your priorities, ETF’s are worth considering. On the other hand, it’s extremely likely that managed funds will outperform ETF’s over the long run in India, owing to market inefficiencies that still abound. For now, it would make sense to make managed, diversified funds the core of your portfolio -  while dabbling in ETF’s. We’re still a few years away from the time that the opposite approach would be more prudent.