ETF Exchange Traded Fund The Innovative Financial Product

Some of the innovations, including the financial ones, are accidental. The ideation and introduction of the Exchange Traded Fund (ETF) is one of them. The origin of ETFs can be traced back to the 840-page report by the US market regulator Securities and Exchange Commission (SEC). The report titled “The October 1987 Market Break’ was an investigation report on Dow Jones Industrial Average (DJIA) steepest fall of 508 points or 22 per cent in a single day on October 19, 1987. This report diagnosed the reason for the fall as ‘portfolio insurance’ and accidentally suggested the product idea of the ETF. The rest is history. In a short span of 25 years (at least in the financial world), the growth in size of ETFs defy all the superlatives. According to a report by E&Y, Global ETF assets, which totalled just USD 417 billion in 2005, had reached USD 4.4 trillion by the end of September 2017 — a cumulative average growth rate (CAGR) of around 21 per cent. India has not remained aloof to this trend and the growth of the ETFs has been phenomenal and has surpassed the growth of the mutual funds in India. 

In India, there are 57 ETFs, other than gold ETFs, having AUMs of Rs 81,272 crore at the end of May 2018. These ETFs account for 4 per cent of the total mutual fund AUMs in India and 11 per cent of equity MFs (including ELSS) at the end of May 2018. Five years back, there were only 23 ETFs in India with total AUMs of Rs 1581 crore and these accounted for less than 0.5 per cent of total AUMs of Indian mutual fund industry. 

We tried to understand the reasons for such fast-paced growth Special Report MF page - 7 and found that the growth in ETFs in India has been primarily led by institutional investors, including the Government of India. The participation by retail investors is still lagging that of institutional investors while investing in ETFs. The reason for this being many investors overlook the benefits offered by ETFs and are reluctant to move away from the comfort of investing in mutual funds, which they know and love. We, however, believe that ETFs can be used by retail investors to diversify their portfolios and enhance their returns. ETFs have become a tool that has democratised investing. A retail investor can now access the very same markets—for the same cost—as the institutional investor. 

The ETFs are designed in a way that provides investors exposure to assets that were previously too expensive or difficult to reach. There is no minimum investment limit in ETFs and hence these are a cheaper way to diversify your portfolio. Only limitation is that they need to buy in units and cannot be purchased in parts like mutual funds. ETFs can track the performance of different underlying, commodity, or basket of assets. If you want to track a specific index, you no longer need to purchase shares in each of the constituent companies. 

What Are ETFs 

ETFs are like index funds that invest in a basket of securities and are traded like an individual stock on the exchanges. An ETF is tied to an index like Nifty, Sensex, Bank Nifty, etc, which decides its holdings. Therefore, an ETF linked to Nifty will hold the same stocks in the same proportion which constitute the Nifty. These are traded on the stock exchanges and you can buy and sell them throughout the day. 

Besides, there are some other defining characteristics that may entice investors to use ETFs in a comprehensive way. The main ones are: ETFs are transparent, listed on exchanges and have a lower fee. 

An ETF’s underlying net asset value is calculated by taking the current value of the fund’s net assets (the value of all securities inside minus liabilities) divided by the total number of shares outstanding. But the ETF’s NAV is not necessarily its market price. 

Since ETFs trade like a stock that you can buy and sell on an exchange, its price is determined by supply and demand. That is why an ETF’s market price can differ from its NAV. Hence there is a concept called indicative NAV or iNAV, which is real time NAV of an ETF. This fluctuates depending upon the fluctuation in the price of its constituents in real time. When there is more demand than the available units on sale, the market price may be 25-50 basis points more than the iNAV. If there are more sellers than buyers, the price may be 25-50 basis points less than the iNAV. 

The design of the ETFs, however, ensures that the gap between those two figures (iNAV and price at which it is traded) is not too high and the difference remains quite small. 

Unlike a regular mutual fund, the fund houses do not deal directly with small investors. If there is not much liquidity in a product you want to buy or sell, you can ask the AMC to give you details of the authorised participant or the market-maker who gives buy/sell quotes. A market-maker is a broker-dealer firm that accepts the risk of holding securities to facilitate trading in those securities. 

Consider these factors before committing your funds in ETFs 

Since ETFs have more characteristics in common with equity shares, investment in ETFs is more suitable for equity investors. Many of the mutual fund investors, who are used to investing a small chunk of their savings regularly, may not find it convenient to invest in ETFs. This does not mean ETFs are inferior to mutual funds in terms of returns. 

Before committing your fund towards ETFs, however, make sure these offers everything you are looking for. You want a high-quality ETF that fits into your investment plan, so you must evaluate ETFs the same way you would evaluate any other mutual fund or stock. 

When considering an ETF, you should also have answers to the following questions: What does the index track, how is it constructed, what is inside and how long has it been around? These are the factors that will help you to zero in on the right kind of ETFs. 

In addition to the above, check out the total costs before investing. An expense ratio tells you how much an ETF costs. The amount is deducted from your account and goes towards paying the fund’s total annual expenses. Remember, the expense ratio does not include the brokerage commissions you pay to buy and sell ETF shares. On an average in India, ETF carries an expense ratio of below 0.1 per cent (for Sensex and Nifty-based ETFs), which means it will cost you Re 1 in annual fees for every Rs 1,000 you invest. The average expense ratio is 0.5 per cent for a traditional index fund with regular option, tracking the same index. There are various types of ETFs tracking various indices and you should be aware of tracking error, which is the difference between the returns of ETFs and the underlying indices. The lower the difference, the better. You need to analyse the tax consequences of your investment. Most ETFs are pretty tax-efficient because of the special way these are built. Do not forget that trading in and out of ETFs can generate taxable gains, just like stocks. The liquidity of an ETF is also an equally important factor as it will decide the impact cost of buying and selling ETFs Therefore, before investing in ETFs you should look at its expense ratio, tracking error and impact cost, and it should have sufficient liquidity. 

Long way to go 

Despite India being one of the fastest growing ETF markets in the world, we lag in terms of breadth and depth of the product offerings in this category. Out of the total number of ETFs available in India, 75% of them follow six indices, of which Sensex and Nifty share almost 50%. 

One of the reasons why ETFs are not popular among retail investors in India is because active funds in India still generate alpha and beat their benchmarks. In addition to that, mutual funds in India are still pushed by distributors or financial advisors. Since ETFs by design are low cost in nature, these have less room to pay commissions at par with actively managed funds and provide little incentive for distributors to promote passive investment. 

If the developed markets are any indication, the future for ETFs in India is bright. The Government of India is at the forefront in creating and promoting ETFs in India by divesting through ETF routes and allowing Employees Provident Fund Organisation’s investments in ETFs. The mutual fund houses in India should also widen their offerings in ETFs in a way that it attracts more investors and fills in any product gap required to make a robust portfolio.