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Many ETFs to choose from

The Indian investor now has the option to make passive funds a part of his portfolio

In a growth economy like India, actively managed funds have successfully beaten the indices. So it's not surprising that exchange traded funds (ETFs) and index funds are often cold shouldered by investors. But that could well change in the future. To hedge their bets, fund houses have now begun to offer a slew of passively-managed products.

Gold ETFs
Gold ETFs have certainly earned their place in the sun. Benchmark Mutual Fund was the first to come up with Gold Benchmark ETF in February 2007. Since then eight Gold ETFs have been introduced. Two of them, ICICI Prudential Gold ETF and HDFC Gold ETF, were launched as recently as July 2010.

In a little over three years, the corpus of Gold ETFs has jumped to Rs 1,799 crore (May 2010) at an annualised growth rate of 151 per cent. At 28.27 per cent, the three-year annualised return has been more than decent.

Gold ETFs invest directly in physical gold, hence the buying or selling price is identical for all the schemes. The returns generated by Gold ETFs at any given point of time are also similar, the miniscule difference between schemes being due to their different expense ratios. So go for the least expensive one. And don't go overboard: limit your exposure to gold to about 5-8 per cent of your overall portfolio.

An ETF with a difference
Motilal Oswal Mutual Fund, one of the latest entrants, has ensured that its first scheme is a fundamentally-weighted ETF - Motilal Oswal MOSt Shares M50 ETF. Like a regular ETF, it will invest in the stocks of a specific index - Nifty in this case. But unlike normal ETFs the weightages will be determined by the fund house. The AMC has built a custom index, MOSt 50, the basket of which will consist of Nifty stocks weighted according to certain in-house fundamantal criteria.

They advantage of fundamental weighting, according to them, is that it reduces exposure to stocks with the highest market capitalisation and aligns the portfolio towards stocks with strong past performance (rather than future potential). The portfolio is regularly rebalanced by selling expensive stocks and buying cheaper ones, thereby taking advantage of the “value effect”.

In the U.S., back testing of FTSE RAFI US 1000, a fundamentally weighted index derived from S&P 500 stocks, produced an average annual return that was 2.1 per cent higher than that of the S&P 500 over the past 42 years.

In India the question is: even if fundamentally-weighted ETFs are superior to those based on market capitalisation, will they perform better than actively managed funds? Let's see how this one performs in the real world.

Looking ahead
The popularity of index funds and ETFs is expected to rise. IDBI Mutual Fund, for one, is actively pushing index funds. They claim passive funds are superior as they have lower costs and they reduce risk (which the fund manager takes to add alpha by buying non-liquid stocks). Besides, they say, index funds offer diversification across the best stocks, so they make good core portfolio holdings.

However, India is still a market where active fund management plays an important role. So let the debate go on. Meanwhile, you choose the fund type that you are comfortable with.