Exchange Trade Funds or ETFs came into existence in the early 90s, and was primarily intended to provide access to passive, indexed funds to retail investors. ETFs are similar to Mutual Funds and are basically baskets of securities that offer access to a specific area of the stock market. An ETF can invest in everything from stocks, bonds,as a passive investment vehicle. It could passively track an index like Sensex or Nifty by holding stocks in the same weightage as the index. An ETF may also track a foreign index like NASDAQ or the S&P500, which might not be easily accessible to the retail investor.
According to the Efficient Market Hypothesis, no fund manager can outperform the market forever and outperforming strategies are quickly imitated and arbitraged away. Hence in the long run, simply investing in the whole market passively tends to outperform active stock picking. If you believe in this financial theory, ETFs are a better product than actively managed funds.
The first ETF, in its true form, the SPDR S&P 500 (SPY), made its debut in 1993 in the US. The Assets under Management (AuM) of this fund as on May 2020 was around $253 billion. From one fund in 1993, the ETF market grew to 102 funds by 2002, and nearly 1,000 by the end of 2009. According to research firm ETFGI, there were nearly 7,000 ETFs trading globally in December 2019. From $1 trillion AuM in 2009, global ETF AuM surpassed $6 trillion, and in Europe it crossed $1 trillion in AuM in 2019. Domestic ETFs received inflows of $5.7 billion (Rs 40,150 Cr) and accounted for a third of the total domestic inflows in 2019.The first ETF in India, Nifty BeEs (Nifty Benchmark Exchange Traded Scheme) based on Nifty 50, was launched in January 2002 by Benchmark Mutual Fund. ETF AuM in India, as on March 31, 2020 was at Rs.1.5 Lakh Crores.
Domestic cumulative inflows into ETF for FY20, stood at Rs 60000 crore, which is about 4 times the net inflows into large cap funds in the same period, and half of the total inflows into equity funds, according to AMFI data.The AuM of ETFs grew 35.4% between April-December 2019, while total equity AuM grew 9.59% in the same period. The share of ETFs in total equity AuM rose by 300 basis points to 18.73% in the same period. All this serves to indicate the growing importance of ETFs in an investor’s portfolio.
What to look at before investing in an ETF
Liquidity: The ETF should provide adequate liquidity. There are two factors that play a role in the liquidity of the exchange traded fund–the liquidity of the shares that are being tracked and the liquidity of the fund itself. Monitoring the liquidity of an ETF is important because while an investment may be profitable, it is important to ensure that one is able to exit when one wants to. It is during market declines that liquidity gets tested.
Tracking Difference / Tracking Error: This is the extent to which the NAV of the scheme moves in a manner inconsistent with the movements of the underlying Index on any given day or over any given period of time. Simply put, it is the disparity between the returns of an ETF and the performance of the underlying index it tracks. It is not just expenditure incurred by the scheme but also the rebalancing costs, tracking methodologies, cash position etc.
Tracking error is a measure of how volatile the performance difference between an ETF and its index is, on an annualized basis.
In India some of the ETFs do not completely track an index, instead, they invest part of the assets in the index, while the rest is used for investing in other financial instruments. This is done in order to increase returns but the tracking error could be high in these ETFs. Sometimes, fund managers will only buy some of the stocks or bonds in an index. A “sampled” strategy will typically aim to replicate an index, but it may over or underperform slightly based on what securities it holds. As an overview, low tracking error means a portfolio is closely following its benchmark, and high tracking error means the opposite. Thus, lower the tracking error the better the index ETF.
Expense Ratio: A fund’s expense ratio is the measure of the cost to run the fund. The expense ratio can include various operational costs like management fee, compliance, distribution fee, etc., and these operating expenses are taken out of the ETF’s assets, thereby, lowering the return for the investors. The lower the expense ratio, the lower is the cost of investing in the ETF.
So can ETFs be compared to Mutual Funds? Yes they can be, in terms of:
Diversification: In case of Index tracking ETFs, you get the exposure to the whole index, or to the category chosen. For example, inNifty ETF you own the complete basket of 50 stocks and remain diversified. You even diversify your country risk.
Small ticket: ETFs are a great tool for investors wanting to start with a small corpus.
Capital Gains: Taxation is similar for ETFs and Equity Mutual Funds.
What are the advantages that ETFs have over Mutual Funds?
Real time Tracking:Unlike Mutual Funds, you can buy and sell an ETF during market hours on a real time basis. Investors can look at a fund that closely tracks the performance of an index throughout the day with the ability to buy/sell at any time, whereby trading opportunities that arise during a day may be better utilized.
Low cost of investment: The passive investment style with low turnover helps keep costs low. ETFs often have lower total expense ratios than competing mutual funds.
Transparent: The underlying securities are known and quantities are pre-defined unlike the monthly factsheets for Mutual funds.
Greater Flexibility: Because ETFs are traded like stocks, you can do strategies like writing options against them, shorting them and buying them on margin.
Disadvantages over Mutual Funds
Brokerages: you pay a brokerage when you buy or sell any security, and ETFs are no different.
General Illiquidity: While trading sounds great, not all ETFs are as tradable as some of the bigger names. Some trade rarely, or only at wide spreads.
No Alpha generation: An Index ETF investor is giving up the potential to outperform (called alpha) since he is only passively tracking the index.An actively managed fund can not only give you the index return but also beat it especially in emerging markets such as India. Additionally, in an index fund, especially considering the liquidity angle, you generally see the largest companies by size, and not too many companies in the small cap space.
Need Demat and Trading Account: Since ETFs require demat and trading accounts investors will need to open such accounts. Many mutual fund investors do not have such accounts since they are not required for investing in ordinary mutual funds.
Things to look out for while choosing ETF
As discussed, ETFs have created the opportunity for investors to gain exposure to entire stock markets or a sector or commodity or a specific market cap in different countries. An investor needs to keep a few things in mind before investing in an ETF. The investor should first understand that the objective of an ETFis not to beat the index but to track the index returns. Yes, we need to look at criteria like the ETF’s expense ratio, or its AuM, or its issuer but the first thing to consider about an ETF is its underlying index. Does the underlying index meet your investment strategy, outlook, and risk appetite? We need to look at the stock exposure, its weightage, etc. You also need to ensure that the ETF has ample secondary market liquidity. Funds with higher average daily trading volumes and more assets under management tend to trade at tighter spreads than funds with less daily trading or lower assets. But even funds with limited trading volume can trade at tight spreads if the underlying securities of the fund are liquid. Investors also need to look at how high the tracking difference is for various ETFs. Individual ETFs will have their own tracking difference, even though the underlying index might be the same. This could be due to the fund manager’s strategy regarding replication of the index, the amount of cash held in the books etc. The lower the tracking difference, the better it is to replicate index returns.
ETFs are gaining acceptance every day mainly because it offers something to all classes of investors. Retail investors prefer it due to its efficient trading, diversification, and the chance to gain exposure to under-represented or under-researched areas of the market. Conservative and new investors also may look at ETFs for the same reasons and also because of its lower cost. For managers and corporates, it represents an ideal option to park idle cash or to manage cash flows. Institutions can meet their asset allocation and hedging needs while arbitrageurs can also use this at a low cost. If a hedge against inflation is required and for Gold investments, investors can look at Gold ETFs to satisfy their craving for the yellow metal. Provident funds are also allowed to raise their equity exposure, via the ETF route. This is not a substitute for your Mutual Funds, but ETFs should have a small percentage exposure in your portfolio and must co-exist with your alpha-generating MF and stock holdings.