Passivity is Popular, but Not in India | Value Research ETFs have become a major force in western markets but their benefits seem lost on Indian fund investors...
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Passivity is Popular, but Not in India

ETFs have become a major force in western markets but their benefits seem lost on Indian fund investors...

In the financial media outside India, recent articles have noted that January 2013 marks the 20th anniversary of Exchange Traded Funds (ETFs). In the western financial markets, ETFs have been an extremely useful and efficacious financial innovation, rewarding both its providers and its investors well. In fact, ETFs are the one exception to the red-flag phrase that 'financial innovation' has become. Unlike much of what passes for innovation in investing, ETFs have greater transparency, as well as lower costs and better returns for the customer. For many smart investors, ETFs have become the only way they'll invest in equity as well as other asset types too.

Unfortunately, ETFs haven't taken hold in India. Eleven years after the first ETF was launched by Benchmark Mutual Fund (now acquired by Goldman Sachs), a mere 1.8 per cent of India's mutual fund assets are in ETFs. In fact, a good part of this too is actually gold ETFs, which for a long time were the only way of investing in a gold fund. If one looks at equity alone—the measure of how investors have actively opted for ETFs then it's far worse—just 0.22 per cent of equity assets are in equity ETFs. The equivalent figure in the western markets is 16 per cent. Clearly, ETFs have been a non-starter in India.

Why are ETFs such a good idea? Mostly, low cost and passive fund management. Such funds are called passive funds because they don't require investment management in the normal sense. There isn't a fund manager who is responsible for deciding what to invest in. Instead, the fund is a replica of a market index like the Sensex or the Nifty or any other index.

While this is true of all index funds, exchange traded funds (ETFs) are a special case of index funds. They are mutual funds but are bought and sold like shares. When you want to buy or sell one, you go not to a mutual fund salesman but to a stockbroker. Unlike a normal mutual fund where you buy and sell units from the fund company itself, ETF units are traded on the stock markets between investors. However, the fund company arranges to absorb any excess supply of units that an investor would like to sell or create fresh units when the demand for units is large enough. As a result, unlike normal shares, the trading price of ETFs is not supposed to be heavily impacted by any demand-supply imbalances. ETFs are inherently very low-cost funds. While an actively managed mutual fund often deducts expenses of up to 2.5%, ETFs are far lower. In India, most ETFs are in the 0.5 per cent to 1 per cent range but large ETFs can be much lower. With compounding, this can build up to a significant difference over time.

The reason for lower costs is that the fund management cost is negligible. The lack of active fund management turns out to be a practical advantage for the customer. There's no scope for doing better or worse than the index so fund selection doesn't matter. Diversification is automatic and assured, regardless of whether you invest in one fund or five.

Unfortunately, the flipside of the low cost is that ETFs don't make much money for the fund companies and distributors. They have taken off in the west because of much higher competition and the presence of large institutional fund investors. Such investors are more focussed on cost and less swayed by marketing hype. In India, a vast majority of equity fund investors are individual retail investors to whom funds have to be pushed. And the push is naturally not for low-margin products like ETFs, and even index funds.

It's a chicken and egg situation. However, the smart and thinking investor owes it to himself to learn about passive investing (both ETFs and normal index funds) and decide whether they make more sense.

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