life in financial markets: ETFs in India

Exchange traded funds (ETFs) are not very popular in the Indian financial marketplace for all the wrong reasons (such as 'fancy for active stock picking based on hot tips or herd mentality investing'). Internationally, they are a big hit but some risks (such as 'low liquidity due to absence of arbitrageurs (that may be on account of very low unit capital of the ETF') are not carefully considered

Anyway, here is something I wrote on ETFs two months ago for the magazine I worked for then:

The promise of ETFs

Very popular internationally, ETFs have not caught the imagination of Indian investors. But they should.

Last year was not a good year for index funds and index exchange traded funds (ETFs) in the domestic mutual fund industry, but only with regard to assets under management (AUM). The combined AUM of 8 ETFs as on 31 December 2009 was Rs 932 crore, just 0.8% of total AUM in non-index equity schemes of Rs 1,96,946 crore. This was an exceptionally low figure as in previous two years, for December-end 2007 and December-end 2008, their proportions were 4.1% (Rs 6,064 crore) and 2.1% (Rs 1,504 crore) respectively.

But, whether vastly popular or not, as it is in many western markets such as US and UK, passive investing has come to stay in India. The lack of high growth in index products is due to reasons such as lack of awareness and perception of deriving more returns from actively-managed equity funds. "But indexing is what someone should definitely be doing," says Gaurav Mashruwala, a leading certified financial planner (CFP). "We advise investors to start with index ETFs."

But differing perceptions hold forth. Says Nilakshi Louzade, a CFP and a partner in financial planning firm, InTrust Advisors, "Index ETF buyers presently comprise of first time investors or very small retail investors but since a large part of our listed companies' growth is coming from companies outside the Nifty or Sensex we do not advise large allocations to index ETFs or funds."

Empirical studies, however, bring out the overall underperformance of actively-managed funds against passive index ETFs. Benchmark Asset Management, the pioneer in ETFs in the domestic fund industry, carried out two such studies in 2009, in May and in December, that confirmed this.

The December 2009 study analysed, for 57 diversified actively-managed equity funds with a 3-year track record as of December 2006, their average rolling 3-year NAV performance (percentage change in the NAV of a given date from the NAV of the same date exactly 3 years ago) from December 2006 to December 2009. This was compared to the corresponding 3-year NAV performance of Benchmark's Nifty ETF.

The 57 active funds, on an average, gave absolute returns that were worse than the Nifty ETF by between 2% and 6% from December 2007 to December 2009. An absolute underperformance of 6% meant that if the ETF was giving a 3-year return of 10% then the 57 funds were giving a return of just 4%, and if the former was a negative 10% then the latter was a negative 16%.

Among index products, index ETFs have got more attractive than index funds. Every time you purchase units of an open-ended index fund the amount gets invested in all the index stocks in the proportion of their weights, but when you buy the NSE-or BSE-traded units of an index ETF the corpus does not change as it an existing ETF unit-holder who is selling the units. In addition to the convenience of holding ETF units in the investor's demat account, this keeps the transactions cost low.

Almost all index ETFs have an annual management expense charge of 0.5% whereas the index funds charge between 0.8% and 1.5% per annum. Index ETFs' tracking error is the lowest. So, for instance, from December 2007 to December 2009, when the spot Nifty delivered a negative return of 12.79%, the Benchmark Nifty ETF gave a negative return of 12.41% and three Nifty Index Funds—of Franklin Templeton India AMC, Unit Trust of India AMC and LIC AMC—gave higher negative returns of 13.49%, 14.10% and 19.56% respectively (see graph).

ETFs hold the promise of providing easy and long-term exposure to different asset classes. Gold ETFs are already a hit in the domestic fund industry (see story on gold in this issue). Benchmark's Liquid ETF offers an easy way to get the same exposure as you would from a liquid fund of any AMC.

The western markets already have ETFs on other asset classes such as currencies and commodities and within equities on sectoral indices such as those tracking clean energy stocks and real estate stocks. Some of these are likely to hit the domestic scene in the coming year or two. For instance, Benchmark AMC has filed offer documents with Sebi in 2008 to launch ETFs on crude oil, silver and government securities and fund of equity ETFs covering the themes of clean energy, private equity and water.

The scope is exciting. Keep the faith and patience.