ETFs: Will they suit you?

ETF or Exchange-traded funds have attracted a lot of investments especially in developed countries, So what are they and whether they will be suitable for our specific requirements, let’s understand them in detail and how should we use them to meet our goals.

1. What are ETF’s?

ETFs are special purpose vehicle i.e. an ETF is a marketable security that tracks an index like S&P CNX Nifty or BSE Sensex, a commodity, bonds, or a basket of assets like an index fund. The ETFs trading value is based on the net asset value of the underlying stocks that it represents. Means Basically ETF represents that particular benchmark with which it is associated with. ETFs provide broad market exposure, low operating expenses and low portfolio turnover.

2. How ETF’s are traded?

Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold (unlike Mutual Funds which are brought/sold at the end of the day NAV).

3. What are ETF strategies?

The strategy for ETF investment is that we don't need to keep monitoring the performance of any specific fund or schemes. However we should also keep this in mind that betting on benchmark indices, can only make market-linked returns.

There could be different type of ETFs like Market Cap based ETFs, Sectoral ETFs or theme based ETFs i.e. consumption, dividend opportunities, long term capital appreciation etc. There are also non-equity ETFs like debt-oriented ETFs and commodities ETF like gold-based ETFs

A passive investor looking to remain invested for the long term, can consider ETFs based on his risk appetite and outlook on benchmark indices. A person can select ETFs linked to large-cap indices like Sensex, Nifty, etc. or mid-cap indices like BSE Midcap 100, Nifty Midcap 100, etc. depending on his specific requirements/risk appetite.

Another set are Sectoral ETFs. These 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.

Other set of ETFs is based on themes—like consumption, dividend opportunities, etc. Stock exchanges have also started introducing new indices--low volatility index, quality index, etc. Few mutual funds have launched ETFs that track these indices. However being a new category, the asset size is very small for these type of funds and it is better to wait for some time to monitor its performance.

The non-equity ETFs like debt-oriented ETFs, bet on the possible movement on interest rates in short or long term.

Among commodities, currently in India only Gold-based ETFs are available. However, they have to compete with recently introduced Gold Bonds.

4. Active versus passive funds; which is better?

While the index funds and ETFs have started attracting major investments in 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. Most large-cap funds have outperformed their benchmark index in the past and they should beat the index funds and ETFs in the future too.

However, this situation may be going to change in the long term. Slowly we are moving from an inefficient market to a somewhat efficient market and going forward the efficiency will increase further. This will bring down the alpha (the additional return generated by managing funds actively) generation capacity of active funds. Falling outperformance is a global trend and as the Indian markets align with the world, their outperformance will come down.

5. What Precautions we need to take?

         (i) Keep it simple:

ETFs mentioned above, except those tracking the indices, are complicated. So we should invest in them only if we understand them properly, or should seek the help of experts. Although we can trade in ETFs on intra-day like equities however we should use ETFs only to align our investment objectives, not for trading.

       (ii) Buy only liquid schemes

Liquidity is a major problem for Indian ETFs, there are several ETFs that are not traded frequently. As they are bought and sold in the markets un-like mutual funds, ETF issuers have no obligation to buy it back from Investors hence an investor has to totally depend on the market for selling and buying them. And, when the trading is less, the bid-ask spread widens, raising the impact cost for both buyers and sellers. So ETF investors should restrict themselves to the counters with sufficient liquidity. To ensure liquidity, choose ETFs that have a large asset base. It is also an insurance against a fund house abruptly closing an ETF if it becomes unviable.

        (iii) Restrict the total exposure

As currently in India the ETF options are very few hence investors should restrict exposure to around 10-15% of total portfolio, and increase it only when more opportunities arise.

                 

Investors often compare ETFs with mutual funds. It's like comparing apple with orange. Every investment is different and caters to the different needs of investors. So while making any investment decisions we should be clear about our risk appetite, investment horizon, financial goals and take experts advise to select the right products.