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Swapnil Pawar, chief investment officer at Karvy Capital, says he'd advise retail investors to invest their entire equity portfolio in exchange traded funds (ETFs). They, then, wouldn't need to worry about reshuffling their portfolio or moving from a non-performing fund to another, which they would have to if they invest in mutual funds. "The only question to ask is if you should invest in the (particular) ETF or not,'' he says.
All financial advisors might not share Pawar's enthusiasm for ETFs. However, they do agree it should be a part of your investment portfolio. The broad advice is to have 10-15 per cent of your portfolio in gold and equity-linked ETFs. With five new ETFs expected in the market this year, let us look at why one should invest in these.
ETFs are units of a basket of stocks which mirror a particular index. The most common are ETFs linked to benchmark indices like the Nifty or Sensex. There are sector-specific indices as well, such as the Bank Nifty and a PSU (public sector units) one. Now, fund houses are planning to launch ETFs benchmarked to the broader indices from the mid-cap and small-cap segments and other sector-specific indices.
The biggest advantages of ETFs are low cost and low risk. Since these are passive investments, they follow the index with respect to the portfolio composition and weights (proportion of shares), without using human interference. Since the returns mirror the indices, ETFs are suitable for investors who want exposure to equity but not the risk associated with managed funds. However, this could also mean settling for lower returns than the latter.
"This investment strategy remains free from human emotions, fear and greed that affect investments over the long term. ETFs are an excellent tool for passive investors and create wealth in the long term without letting short-term market noise affect the yield,'' says Achin Goel, head, wealth management and financial planning, Bonanza Portfolio.
In India, though, there are fewer takers for ETFs because historically active fund managers have generated significant alpha over the underlying benchmarks.However, as Pawar notes, "If we look at returns by separating alpha (returns generated by the fund manager) from the beta (returns generated by the index), we can see that beta contributes 80-90 per cent of the return. Then, why should one pay an expense ratio of two per cent or more?"
Another reason why ETFs are not popular is that there is no commission, due to which they are not actively sold, unlike MFs. Also, for retail investors, the requirement of opening a broking account can be cumbersome, which is why many shy away from ETFs. "To invest in an ETF, one has to open a trading and demat account, which might have account opening charges. Variable costs like brokerage, transaction charges and other statutory charges like stamp duty, securities transaction tax (STT), etc, need to be paid by the investor every time an ETF is bought and sold,'' points out Rashmi Roddam, director, WealthRays Securities.
We list some pluses with ETFs:
Portfolio diversification
ETFs allow investors to diversify across domestic indices (Nifty, Sensex), gold, money market, sector-based and global indices. "ETFs give investors the opportunity to invest in a basket of stocks focusing on a particular theme/sector. The other way to do this is to buy the stocks individually, a tedious task," says Rajesh Saluja, managing director, ASK Wealth Advisors.
Lower cost
ETFs don't incur the administrative costs that MFs incur for correspondence, customer service and account record keeping. Due to this, the total expense ratio is low. Costs related to any short-term inflows or outflows into MFs, such as STT, brokerage and market impact costs, impact all the investors in that fund. But in the case of ETFs, the cost of trade while buying or selling the underlying ETF basket shares is borne by those particular investors only. Thus, long-term investors into ETF are not impacted by inflows/outflows from the ETF.
"The average expense ratio of an equity ETF is around 0.61 per cent. In comparison, in case of open-ended equity funds it is 2.24 per cent and in case of index funds it is 1.16 per cent)," says Saluja.
And, some minuses:
Liquidity
Since participation in ETFs in India is still low, liquidity can be a challenge. "You need to check for the ETF's liquidity before investing. If the liquidity is low, you might incur heavy losses owing to the high spreads between buy and sell prices'' says Goel.
Active management versus ETFs
Emerging markets such as India are not very mature and often lack adequate depth. The mispricing opportunities in these markets allow alpha generation through active fund management, which can score over passively managed products despite a higher expense ratio, points out Saluja.
Tracking error
At times, when there is heavy buying and selling by an asset management company with their authorised participants, the cash levels can result in some tracking error, that is, a deviation in the performance of the fund and the underlying index. This way the ETF might underperform the index it is tracking in the long term.
