etf

Published in FINANCIAL PLANNING JOURNAL: June 2011

Exchange Traded Funds: A Promising Investment Vehicle

Exchange Traded Funds (ETFs) are the investing innovation that combines the best features of mutual funds, especially index funds, with the trading flexibility of individual securities. Globally they are widely used by planners as the efficient and cost effective tool to take advantage of investment opportunities around the world. In India, they have witnessed major developments over the past couple of years. Some of these developments, such as consistent growth in their volumes both in terms of trade and turnover on stock exchanges and launches of new funds are
positive but some others such as concentration of assets in Gold ETFs, low retail investors’ participation and disinterest of advisors in promoting ETFs may not be supportive for the balanced growth of ETFs. These changes obviously affect practices of planners and therefore their effect should be carefully examined. This writing intends to explore ETFs with a comparative view of global trends.

Types of ETFs

ETFs can be classified on the basis of their management style, the underlying asset and their investment in different regions.

Globally ETFs have several variants among each asset class. Foreign ETFs such as country specific, regional, developed and emerging market ETFs are widely used for geographical diversification. Many of these variants are still relatively new or yet unavailable in India. As planners, we have confronted investors’ query on Gold ETFs. But other ETFs are yet to catch investors’ interest. Currently we have 26 ETFs and all are of passive style except one which is fundamentally weighted ETFs. Among commodity ETFs, the only one available to us is Gold ETFs. As new variants will be rolled out, price competition among providers and better variations of product will be witnessed. An interesting example is Silver ETFs which may be launched in India very soon.

Benefits of ETFs

ETFs offer several advantages to be a legitimate part of a portfolio:

· ETFs have an edge over index funds in the types of asset classes covered and their ability to offer intra day liquidity. The tracking error of an ETF is, normally, lower than that of an index fund.

· Keeping investment costs low is crucial to reaching one’s financial goals. Every rupee paid towards the investment company's overhead is a rupee that disappears from net returns. Being listed on stock exchanges, ETFs don’t incur distribution and other operational expenses. Index ETFs don’t involve the cost of active fund management and high turnover and therefore are the cheapest among mutual fund variants.
· The investment objectives of ETFs are easy to understand. Understanding the underlying asset or index makes it clear that whether the ETF fits in the portfolio or not.
· ETFs also offer diversification and simplicity of transaction.

The Role of Exchange Traded Funds in a Portfolio

To reap the true benefits, ETFs should be employed strategically. They are effective tools for both long term and short term or passive and active investment strategies. Not only individuals, but even institutions use them tactically abroad. Pension funds, insurance companies, investment managers etc use ETFs in various types of strategies such as to reduce the impact of gaps in style, size or sector tilt weight and to manage regular inflows and outflows of cash. To determine what role ETFs would play in a portfolio, let us understand how to use them in different investment strategies.

Asset Allocation Strategies: ETFs tracking major market indices are one of the best options to be a part of the core portfolio. They easily fill asset allocation gap and can be used tactically to reduce an overweighting or underweighting position of a portfolio. Thus they also help planners in rebalancing strategies. Specialised ETFs with low correlation to the core portfolio balance the asset allocation and augment risk-adjusted return. Gold ETF is one of the best examples of specialised commodity ETF as gold don’t have a prominent correlation with debt and equity.

Cash Drag Minimisation: ETFs are the perfect vehicle to move frequently into and out of an entire market or a particular market niche and therefore are great short term investment options for the active part of the portfolio. As they are enough liquid, they could be a temporary investment to park the idle cash of a portfolio which is allocated to the equities. This minimises cash drag and avoid potential opportunity cost till the time investment decisions are taken to put that money in work. In such a way, ETFs can be used as alternative of derivatives which has been used to have temporary exposure.

Loss Minimisation: If the gain of the stock investment needs to be protected, ETFs may be sold short. A better hedge can be obtained by trying to match the characteristics of the index or underlying asset the ETF is based on, with the characteristics of the portfolio being hedged.

Arbitrage Opportunities: ETFs also present arbitrage opportunities which eliminate any possibility of trading at premium or discount to the NAV. When the price of an ETF deviates from the value of the underlying securities an arbitrage opportunity appears. This type of movement was noticed in Gold ETFs last year. On 26th May 2010, the closing price of Gold Share ( a Gold ETF) was Rs. 1787.65 and the NAV was 1846.77 with a difference of 3.20%.

Taxation:

Taxation is a very important aspect in financial planning and current Indian income tax laws favour ETFs. All equity ETFs are taxed as per equity mutual fund taxation while any non-equity ETFs are taxed as per debt mutual fund taxation. Therefore Gold ETFs provide an additional benefit over investment in physical gold as they enable to claim long term capital gain after a period of one year of investment and also aren't subject to wealth tax.

It should be noted that the transaction costs of ETFs (the brokerage charged by the stock broker) also include certain statutory charges. These charges cover service tax, education cess, stamp duty, STT etc.

Limitations of ETFs: A Comparative Study

Just like other investment options, ETFs are not free from limitations. First of all, they are exposed to bid - ask spread. What sellers are willing to get may be more than what buyers want to pay and a wider spread eats returns of ETFs. For the well traded ETFs, spreads are usually tiny, but for ETFs with lower assets or volume, the gap can be much wider. Sometimes an ETF’s market price can drift away from its net asset value. This may result from some persistent illiquidity in the underlying securities and such situation creates the opportunity for arbitrage which sets the price of ETF back to equilibrium.

If we take a comparative picture of global v/s Indian trends, domestic ETFs are far away from their global counterparts. U.S. market for ETFs is almost of $ 1 trillion. At the end of February 2011, there were over 2,557 ETFs with assets of US$1367.4 billion. Domestic ETFs have the AUM of only Rs. 6916 crores (as on 31st March 2011) and 64% of this is concentrated in Gold ETFs.

There are a few limitations which implies particularly for ETFs in our mutual fund industry. The one which is most important from financial planning perspective is the limitations associated with indices. As against the plethora of indices available in the international market, India has just two popular indices- Nifty and Sensex. Sensex with just 30 stocks and Nifty with 50 stocks cover a relatively small number of stocks and ignore many opportunities in the midcap sector. They are also skewed towards a few sectors and stocks. Therefore domestic ETFs have not been able to challenge other equity funds on the ground of performance. To understand it, we will compare the return of a typical index fund- HDFC Index Fund- Sensex and an index fund with an element of active fund management, i.e. HDFC Index Sensex Plus. Upto 20% of the net asset of HDFC Index Sensex Plus is actively managed. Having equal expense ratio, it has delivered almost 40% extra return in one year and 57% extra return in 5-year horizon in comparison of HDFC Index Fund - Sensex (as on 31st March 2011). The fact is that many actively managed funds comfortably outperform the index over longer time frame. India is a developing economy and many stocks are still underresearched here. This gives fund managers several opportunities to outperform the index.

With the end of mutual fund entry load regime, the transaction cost of an ETF may look like an additional cost. Further it is argued that passive funds shouldn’t have high expenses. To examine it, let us have a look at the expense ratios of a developed mutual fund market like the US.

Domestic ETFs have expense ratio in the region of 0.50% to 1.50%. Small size of AUM is the main factor behind high expense ratio. With the growth of mutual fund industry, this ratio is expected to decline.

Planner’s Outlook:

The scope of ETFs will increase as our market matures. But today there are few options available in ETF industry and only a planner can help his clients to get the best from ETFs. While designing an appropriate strategy according to his client’s requirement, planners need to be very careful so that the associated limitations mayn’t put any adverse impact on the investment target. ETFs have witnessed apathy from both mutual fund advisors and stock brokers and therefore planners need to play a larger role here.