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Index Funds and ETFs - Why they beat actively managed Portfolios

"A low-cost index fund is the most sensible equity investment for the great majority of investors." – Warren Buffet

A good financial decision is a pillar which encourages firm financial stability. While we have innumerable choices to opt for, amongst financial services or instruments, it is equally important to have abundant knowledge of such services or instruments to track our returns. Likewise, the Indian financial markets include a variety of stocks, bonds, etc. with lucrative returns one could invest for. Apart from conventional products like stocks, and bonds, Exchange Traded Funds (ETFs) are gaining momentum in the Indian financial market in recent times. This has created a pool of opportunities for investors to invest in. The risks associated with investments though are a factor to be taken into account but also the returns from such investments are relatively higher. Similarly, in the case of ETFs, the risk is less and one doesn’t need to be a genius investor to invest in ETFs. An everyday effort to track down the index funds would provide a stable income daily. Some of the eminent players involved in the issuance of ETFs are Nippon India ETF, NIFTY BeEs, Motilal Oswal MidCap 100 and the list go on.

The popularity of Index Funds or ETFs as trade investments is the talk of the town, nowadays. Before analyzing the reality of such funds being active portfolios, it is essential to understand the basics of ETFs. Exchange-Traded Funds or ETFs are a bucket of securities that are traded and have a trait of an index like BSE or NIFTY. ETFs include the characteristics of a mutual fund and also at the same time that of regular stock, this has brought in a lot of advantages. Retail investors along with institutional money managers are exposed to a whole new world of investment opportunities. The most intriguing part about ETFs is that they bring in lower costs and reach out to various stock markets globally and they are sector-specific to have real-time access. Buying an ETF and holding it for the next 10 years isn’t a good strategy rather it needs a shrink-wrap strategy solution. Market makers can create units at 0.25% above the Net Asset Value (NAV) and buy back units at 0.25% below NAV in normal circumstances. If 0.25% is further fragmented then 0.1 is for the Short Term Deposits (STD) that one needs to pay for buying or selling the security. The next 0.1 is for the funding cost that market makers need to pay by borrowing money. The remaining five bits are for the brokerage.

The underperformance of active investments made the investors shift their focus towards passive low-cost investments i.e. ETFs. The advantage of passive investing over active investing was that they don’t require special attention from fund managers for predicting the growth. The fund’s expense ratio is relatively cheaper than that of regular equity.

The trading value of ETFs is calculated from two angles. On one hand, it is calculated by ascertaining the net asset values of the stocks covered within them and if we considered it as mutual funds then it is calculated as the buying and selling value at a price that would fluctuate according to the market forces within a day. There are future markets to ETFs i.e. NIFTY future, Bank future, etc. Future Markets is a platform wherein participants buy and sell commodities also the future delivery of commodities are specified. In the case of ETFs, one doesn’t need to go to the markets to purchase the securities; he/she can directly approach the fund house (asset management companies who invest in financial instruments on behalf of the investors) to buy the same.

The history of how ETFs came into existence in India holds an enthralling tale to it. Benchmark Mutual Funds initiated ETFs in the year 2001 in a motive to observe the performance of NIFTY-50. It was done keeping in view the emerging trend in passive investment. Benchmark later diversified the portfolio of ETFs by launching fixed income ETF and gold ETF.

When Benchmark initiated the ETFs in the year 2001, there were two challenges. One was that there were no market makers and the second was that SEBI didn’t have any specified definition to define a market maker in India. Benchmark tried to portray the significance of the Authorized participants in front of SEBI in recent times. It is a well-established channel in the USA. The whole channel works as to suppose there are five Authorized participants in an ETF then it is only those five individuals who can directly approach the Asset Management Companies (Companies that put clients’ capital into investments by taking pooled money from the clients) for creating and redeeming ETFs. It is the scenario of the markets in the USA. In the case of India, as long as one is an investor then only he/she can create a lot of sizes and redeem the units. Technically, any investor can create and redeem the ETF units. So, when ETFs were introduced by Benchmark, only institutions could approach them directly. The whole problem was that no institutions could create baskets in return for units. For example, if ICICI bank wants to create a basket of NIFTY BeEs (first ETF in India) where the underlying index also has ICICI bank, then ICICI bank cannot buy its own shares and then create its own basket. So, Benchmark approached SEBI with an idea to initiate a cash subscription route which would help a lot to function the channels. It has been a popular approach in India today. Gradually, Benchmark Mutual Funds transferred the ownership of the business to Goldman Sachs in the year 2011. Later in the year 2015, the ownership was then transferred to Reliance Mutual Funds.

It can be inferred that with time, ETFs became a popular source to invest in gold. The composition of ETFs in the initial stage consisted of gold funds during the period 2009 to 2014. In the year 2012, the investment in gold through the usage of ETFs became a trend but then the investment in gold funds through ETFs faced a declining trend.

Liquidity is an important aspect when it comes to any security, not just ETFs. An example would make the subject explicit. Suppose the NAV is 100 and the 50 underlying securities are not liquid then the impact of executing the basket may turn out to be 100.50. In the later phase, when he/she decides to sell the basket in the market then the selling price would gross up to 100.50 plus charges. Now, if the same basket consisting of those 50 securities is very liquid then it would reduce the cost to 100.10 and he/she can sell the basket in the market at a much cheaper rate gaining a competitive advantage over other players.

The question which underlies now is how to choose an effective ETF. As we know, an ETF is a basket of securities. The choice lies in the combination one would opt for. If one hits a basket or underlying index where liquidity is not high enough, the trading cost of an ETF would turn out to be higher than desirable. On a brighter side, the impact cost of executing the basket in a fund is higher than it reflects in the bid and spread. If an ETF is illiquid in the market then that would add to the impact on the client.

The performance of ETFs, in 2015 and beyond, has not only been enhanced but also has been more diverse. The growth of assets under management for ETFs has shown a phenomenal increase. It has grown initially from INR 13,800 crores to INR 1, 41,500 crores in mid-2019 which is approximately a 1000% increase in a short span of time. At the same time, the Compound Annual Growth Rate of ETFs stood at 55%. The credibility of such growth of ETFs lay with the equity segment.

Political, economic, and legal factors play a major role in influencing the financial market. Likewise, two of the external factors contributed to the tremendous growth of ETFs in recent trends. In the year 2014, the major turn-point which attributed to the growth of ETFs occurred when the Government used ETFs as a source to divest the shares in Public Sector Undertakings. This led to the launch of Central Public Enterprise Services (CPSE). A similar event also pushed the growth of ETFs high when the Employee Provident fund Organization (EPFO) decided to take exposure to equity through ETFs. The funds increased in the ETFs as the people started contributing to provident fund and personal provident fund.

The government had also mandated the retirement and superannuation fund to contribute 5% to equity markets. This prompted many to use ETFs for such investments.

According to the experience of one of the ETF investors, he placed an order of INR 135 crore ETF in a single day through the mid-cap fund segment on the exchange for institutional clients. While many consider mid-cap to not be productive but the investor raised a huge order in asingle day through ETFs which in turn is a remarkable story by itself.

Recently, the most challenging turn which hit the markets hard was the coronavirus pandemic. The interest of the investors was at stake because of the uncertainty prevailing in the system. People were skeptical about their moves as no one knew what was going to happen the next day. Likewise, every financial product has an ecosystem. Once the ecosystem breaks down, the product will also break down. Due to the pandemic, the ecosystem of ETFs faced a breakdown. Vix Index (Metrics used to measure volatility) which used to trade at 13-14, was trading at 80. It was because there was an uncanny vibe among the people whether the financial market would open in the near future. Gradually, the ETF ecosystem revived and the position is better than before.

Many of the ETFs positioned with the new normal ETFs are gaining momentum after the pandemic lockdown and are expected to bring in much productivity in the future of ETFs. With a rise in inflation, the purchasing power and the investing power of the consumers have decreased but ETF seems to be a savior at the moment. The low cost and the ease of investment features of ETFs have pushed the growth of the ETFs for which they are now the most traded securities among many.

Author: Arushi Mallick.

Disclaimer: Note that this post should not be construed as investment advice from Galactic Advisors.

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