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Are Exchange Traded Funds good for you? Find out

Exchange-traded funds have attracted a lot of investments but find out if they suit you. Here’s a primer that will help you make up your mind.

, ET Bureau|
Updated: Aug 14, 2017, 10.02 AM IST
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Should you opt for ETFs? What about investing in ETFs in general? Here’s a primer that will help you make up your mind.
The debate between choosing actively managed mutual funds and passively managed schemes like index funds or exchange-traded funds (ETF) has got shriller with the announcement of the government’s plan to introduce Bharat 22 ETF.

Should you opt for it? What about investing in ETFs in general? Here’s a primer that will help you make up your mind.

Active versus passive funds
While the index funds and ETFs have started attracting a big chunk of the investors’ money in the developed markets, these passively managed funds are yet to pick up in India. This is because the actively managed funds continue to outperform their benchmarks. The category average of actively managed large-cap funds has beaten the Nifty index across time periods, and this trend may continue in the immediate future.
“Most largecap funds have outperformed their benchmark index in the past (even after accounting for higher expenses) and they should beat the index funds and ETFs in the future as well,” says Rajat Sharma, CEO, Sana Securities. However, this situation is going to change in the long term, say experts. The asymmetry of information—Indian fund managers have better access to company managements compared to other investors—is one reason for the outperformance of actively managed funds.

Active funds score better
As the market matures, the outperformance of active funds will fall substantially.

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But the situation will change with more transparency and due to the improving pricing efficiency in the Indian market. “We have already moved from an inefficient market to a somewhat efficient market and the efficiency will increase further in the next 5-10 years. This will bring down the alpha generation capacity (of actively managed funds),” says Ankur Kapur, Managing Partner, Plutus Capital. Jitendra P.S. Solanki, a Sebi-registered Investment Adviser, concurs: “Falling outperformance is a global trend. As the Indian markets align with the world, their outperformance will come down in the long term, say in 10 years.”

ETFs with the lowest charges...
The low cost of ETFs—expense ratio less than 1%—is their prime attraction.

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...those with the highest charges
The high expense ratio strips these schemes of the key benefit of low costs

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Source : Accord Fintech, Complied by ETIG Database. NAV, market price as on 8 Aug 2017. AUM as on 30 Jun 2017.

Index funds and ETFs
ETFs are a subset of low-cost index funds. The difference is that ETFs are listed on stock exchanges and you can buy or sell them like stocks. “I prefer ETFs over index funds because of real-time investment and lower tracking error,” says Solanki. Low tracking error means the fund’s portfolio closely follows the benchmark index. Low expense ratio, even compared to index funds, is another factor that makes ETFs attractive. “I like ETFs because the expense ratio of index funds are still high in India,” says Deepesh Raghav, a Sebi-registered Investment Adviser.

While most index funds continues to charge 1-1.5% as expense ratio, the cost structure of ETFs has fallen drastically in the recent past, thanks to the competition on account of the investments from the National Pension Scheme (NPS) and Employee Provident Fund (EPF). There are several ETFs now that charge less than 0.1%. However, several theme-based ETFs continue to charge higher expenses.

ETFs with lowest liquidity
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Funds trading above their NAVs
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Funds trading below their NAVs
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Since the liquidity is low, several ETFs are not trading close to their NAVs

Source : Accord Fintech, Complied by ETIG Database. NAV, market price as on 8 Aug 2017. AUM as on 30 Jun 2017..

ETF strategies
ETFs are special purpose vehicles meant for select investors. You should carefully assess whether they suit your needs. For starters, one should know the different types of ETFs: First, there are ETFs based on benchmark indices. If you are a passive investor looking to remain invested for the long term, you can consider these low-cost funds. Depending on your market-cap orientation, you can select ETFs linked to large-cap indices like Sensex, Nifty, etc. or mid-cap indices like BSE Midcap 100, Nifty Midcap 100, etc.

The main advantage of this strategy is that you don’t need to keep monitoring the performance of your funds. But, bear in mind, your returns will also be market linked. “By betting on benchmark indices, investors can only make market-linked returns. So this strategy is only for the really passive investors,” says Sharma. The next set of ETFs are based on sectors— banking, infra, etc. These sectoral ETFs are for more advanced investors who are bullish on a particular sector, but don’t have the expertise or time to select and monitor stocks from that sector. But some experts caution: “If you are bullish on a sector, direct equities will be better. By doing that, you can avoid buying some of the laggards from a sector (which maybe a part of the ETF),” says Kapur. The third set of ETFs is based on themes— consumption, dividend opportunities, etc

Stock exchanges have also started introducing new indices—low volatility index, quality index, etc.—and mutual funds have launched ETFs that track these indices. Since this is a new ETF category, with a very small asset base, it is better that investors wait for some time to monitors their performance. There is also a dedicated ETF for the religious minded— Reliance ETF Shariah BeES. There are also non-equity ETFs. For instance. Debt-oriented ETFs, such as SBI 10-year gilt and LIC MF Long Term G-Sec, bet on the possible movement on interest rates. Among commodities, only gold-based ETFs are available in India. These help track gold price movements without one having to bother about purity issues, making charges, etc. However, with the introduction of gold bonds, they have lost their sheen. While gold ETFs charge an expense ratio of around 1%, gold bonds give an interest of around 2.5%— the difference in returns will be around 3.5% per annum.

Take precautions
As a first step, investors should understand that the ETFs mentioned above, except those tracking the indices, are complicated. Invest in them only if you have the domain expertise. If you do not have the necessary skills, but are keen on investing, take the help the experts. One advantage of ETFs mentioned above is that you can buy and sell them on an intra-day basis, just like stocks. However, investors should not get carried away. “Investors should use ETFs only to align their investment objectives and should resist the temptation of trading,” says Solanki.

Opt for liquid schemes
While low cost is a positive for ETFs, lack of liquidity is something that’s plaguing the Indian ETFs. There are several ETFs that are not traded frequently. And, when the trading is less, the bid-ask spread widens, raising the impact cost for both buyers and sellers. “In case of index funds, or actively managed funds (unlike ETFs), investors can sell units back to the fund houses without any impact cost. So ETF investors should restrict themselves to the counters with sufficient liquidity,” says Raghav.

Size matters
One way investors can ensure that their ETFs remain liquid is by sticking with ETFs that have a large asset base. Large assets under management (AUM) is also an insurance-ofsorts against fund houses abruptly closing an ETF. “Funds have closed several ETFs in the past, some of ETFs will get closed down in the future also, if it becomes unviable for the fund house to keep ETFs with a very small size,” says Kapur.

Restrict your exposure
Though ETFs offer good opportunities, don’t go overboard with them as the ETF market in India is still quite nascent. “Since ETF options are limited, investors should not go overboard. As a precaution, they should restrict exposure to around 10-15% at this time, and increase it later when more opportunities arise,” says Solanki.


BEST TO AVOID BHARAT 22 ETF
Experts are unanimous in saying that investors can avoid Bharat 22 for several reasons. First, the offering goes against the basic concept of ETF, which usually track an existing index. In Bharat 22, the government will release a list of stocks that it wants to divest and then Asia Index Private Limited will create a new index based on these stocks.

The biggest drawback of Bharat 22 is its fixed set of stocks. This rigidity is not there even with Nifty or Sensex ETFs. Index-based ETFs usually change portfolios when there is a change in index stocks. The stocks in Bharat 22 are just stocks that the government wants to divest. Buying Bharat 22 will be akin to buying something where the selection is made by the seller, not the buyer. Timing is another worry for possible Bharat 22 investors¡Xhere the government choses the best time to sell, so that it gets the best price.

While the government's CPSE ETF only consisted of PSU stocks, in the case of Bharat 22, it plans to sell some of its stake in blue chips like ITC, L&T, etc. as well. But experts are not convinced that this should be reason enough for investors to buy Bharat 22. "It seems the government is trying to get rid of some of the not so well performing companies by clubbing it with other blue chips,¡¨ says Sharma.

In other words, the stocks here are not selected based on any sector or theme, so investing in this ETF doesn't serve any purpose. Bharat 22 is also not diversified enough, and if investors want a well-diversified ETF, they can go for some low cost Nifty or Sensex ETFs. And if investors want to take a concentrated bet on PSU stocks, they can go for CPSE ETF.
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