Their Story. Why they say no to ETFs

Exchange Traded Funds, which are very popular in developed markets, have not really taken off in Indian markets. Sample this: there are 1,577 ETFs traded on the NYSE, 1,109 listed on Deutsche Börse and 2,315 ETFs on London SE group towards the end of December 2015, according to World Federation of Exchanges. But the National Stock Exchange trades just 54 ETFs.

Exchange Traded Funds (ETFs), as their name denotes, are mutual funds that are traded on stock exchanges and bought and sold like stocks. They mostly track an underlying index and are passive investment tools, that is, the fund manager has no role to play in ETFs. The expense ratio is, therefore, much lower in ETFs.

The ETFs listed on Indian exchanges are typically based on equity indices (local or international), gold or debt. Unfortunately, awareness of ETFs in India is very low and mostly limited to gold ETFs. The asset size of ETFs is, therefore, very small — about 2.5 per cent of the size of the entire mutual fund industry.

Of the ETFs listed and traded in India, gold ETFs account for almost half the assets. So, what do investors think about these products?

Balamurali Radhakrishnan, an economist and financial analyst from Bengaluru, strongly believes that ETFs have an edge over actively managed funds. “If I want to invest in an actively managed fund, I will have to carry out thorough due diligence in order to choose a fund that has consistently performed well and to assess the return it has delivered,” he explains. “When it comes to investing in an ETF, all I need to know is which direction the economy is moving in. If the economy is in recovery mode, I will put my money in index ETFs, and consider exiting the positions in case of the exact opposite scenario. I don’t need to spend a lot of time studying the performance of fund houses.” 

Adarsh Kulkarni, an independent financial analyst from Hyderabad, thinks that a part of one’s portfolio should definitely be allocated to ETFs. Adarsh, who earlier worked with Franklin Templeton in the NAV analysis division, thinks that the most important point in favour of ETFs is their lower expense ratios.

Basavaraj Tonagatti, a Certified Financial Planner and an active personal finance blogger, thinks that the lack of choices in the Indian ETF array is a restricting factor.  “Investors who are looking for low-cost equity investing which replicates the Index like Nifty, may definitely consider ETFs. But those who want a well-diversified portfolio may stay away from ETFs due to lack of options in ETFs,” he says.

The Indian mutual fund industry and Indian stock markets are in the growth phase over the last quarter century or more and it has been easy for fund managers to outperform the indices. But as markets mature, it will be difficult for funds to do better than the indices and passive investing or index tracking is a good way to invest. ETFs are, therefore, products of the future.

The NSE states on its website that in the US, in the last 20 years, an estimated 65-80 per cent of fund managers have under-performed the S&P 500. Long-term investors who wish to invest only in large-cap stocks might be better off investing in ETFs as expense ratios are far lower.

So, what’s stopping the ETF market from growing in India?

The most important reason why ETFs are not popular is because mutual funds do not make any special effort to market them. Distributors also do not peddle them aggressively since they seldom get commission on selling ETFs. In the US, ETFs grew in popularity once commission on mutual fund distribution was removed and distributors’ earnings were made fee-based. The differential commission structure between ETFs and mutual funds is the most important reason for the lower marketing and awareness.

“Financial advisors play a critical role in helping ETFs reach investors. But to get them to sell ETF products, fund houses need to pay them well. That might not be a problem for actively managed funds but the passive fund sector struggles to do so, especially as it is a low-margin business,” says Balamurali.

Two, since demand is low, fund houses have not launched new products. “Lack of options makes it difficult for investors to diversify their portfolio,” says Basavaraj. Investors can now take exposure to only a few indices, such as Nifty, Sensex, Bank index or Junior Nifty. But this can change if other strategic and thematic indices launched by the BSE and the NSE are used to issue ETFs.

Some feel that while demat accounts are not mandatory for mutual funds, ETFs need both trading account and demat account. This is a deterrent for those who do not like to deal with stock markets. The extra cost of opening a demat account is also a drag, according to some investors.

“Another drawback is the lack of liquidity,” says Basavaraj. This not only makes buying and selling difficult, but can also distort pricing. The tracking error increases in this case, making the ETFs far away from their NAVs.

Of the limited options available, which ETFs do Indian investors buy? “Being a typical Indian, I want to have exposure to gold. So, I do invest in gold EFTs and occasionally index ETFs. But, going forward, I may divert a part of my incremental savings towards gold bonds, which also look quite attractive to me,” says Balamurali.

“I prefer Nifty index ETF to gold or banking because I prefer the diversification that Nifty provides. In addition, I try to avoid gold as an investment since gold has given a return akin to debt, but with the volatility of equity. So why take the risk?” asks Basavaraj.