Yes, ETFs have a future | Value Research ETFs have badly lagged active funds so far. But lower costs, institutional flows and smarter indices could make all the difference
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Yes, ETFs have a future

ETFs have badly lagged active funds so far. But lower costs, institutional flows and smarter indices could make all the difference

Yes, ETFs have a future

On the face of it, it may be puzzling that Reliance Capital Asset Management, already one of the largest fund houses in India should choose to acquire Goldman Sachs AMC, which primarily manages passive Exchange Traded Funds (ETFs).

We all know that ETFs, which are such a big hit in the developed markets, have not taken off in India. The total equity assets managed by ETFs, at ₹8,920 crore as per AMFI data is not a patch on the ₹3,47,000 crore managed by active equity funds.

The reason why ETFs, particularly equity ETFs, haven't grown much, is clear from the fund performance rankings. Take any fund category and take a look at 1, 3 and 5 year returns. You'll find ETFs huddled somewhere at the bottom of the category while active funds are trouncing them by big margins.

In the large-cap category, for instance, the Goldman Sachs CPSE ETF, with negative returns of 14 per cent is the bottom ranker and most Sensex and Nifty tracking ETFs are in the lowest quartile (2-3 per cent returns), while top active funds have delivered 15-19 per cent for the last one year.

But if Reliance Capital has still decided to acquire an ETF-based fund business and at a fairly good price (over 3 per cent of assets) that's probably because it foresees a much brighter future for ETFs in India over the long term. This may be hard to imagine today, but a brighter future for ETFs in India could emerge on three counts.

The cost factor
One, one key reason why active managers across the world are now losing market share to ETFs, is that ETFs come at ultra-low costs compared to active funds. Now globally, active fund managers struggle to outperform their chosen benchmarks. If at all they do, they manage to beat them by only a whisker. Therefore, ETFs which offer to deliver index returns at a fraction of the costs seem like an attractive proposition.

In India, there's a fairly large gap between the costs charged by active funds and those charged by ETFs. In the large-cap equity category, most funds charge 2.75 to 3.10 per cent annually as expenses. ETFs from Reliance MF, IDFC, SBI and HDFC now charge as little as 0.20-0.30 per cent. But because the performance gap between the ETFs and the top active funds is as high as 10-11 per cent, no one pays much attention to ETFs. But what if the performance gap were to narrow over the next few years?

Currently the return gap between active funds and ETFs is high because several sectors that carry sizeable weights in the index - PSU banks, energy, metals, infrastructure - are underperforming because of a sluggish economy. Active fund managers outperform by avoiding these sectors. But if a more broadbased rally begins, active funds can surely not deliver such high margins of out-performance against their benchmarks.

In fact, top equity fund managers do admit that outperforming the indices by more than 3-4 per cent on a consistent basis would be difficult. In that situation, an expense ratio of 3-odd per cent may make all the difference to returns. If ETFs in India slash their fees like in global markets, they can then truly give active funds a run for their money.

Institution effect
Two, there's the institutional money flow. Globally, institutional investors testing the waters in a new market always use low-cost, low-risk ETFs to take their exposures. As more global pension funds, trusts and other institutional investors enter the Indian markets, they too may buy ETFs over active funds simply because that's what they're used to doing globally.

Not just global institutions. Local ones like the EPFO and other pension funds too are likely to invest their substantial kitty in index stocks, if not ETFs, to ramp up equity exposure. As the money from domestic institutions can be a sizeable force in the markets in the years to come, this can lift the prices of index stocks and make it harder for active funds to beat ETFs.

Smarter ETFs
Three, one hopes that India would have much more innovation in the ETF space in future. Today, a majority of ETFs here track gold, the Sensex or the Nifty or PSU stocks. Now, market bellwethers like the Nifty or Sensex are designed to be accurate barometers of the market mood. They are made up of the largest, most liquid names in the stock market and not necessarily those with the best future prospects or fundamentals. Plus, as these indices are market float weighted, they automatically raise weights to momentum stocks.

ETFs which passively mirror these indices also suffer from the same shortcomings - they select stocks for their liquidity (not the underlying business) and they weight them based on recent performance. This is one reason why even a halfway intelligent investor can beat these ETFs.

Globally, ETF managers have solved this problem by floating Smart Beta ETFs. They are based on specially constructed indices that feature stocks better suited to long term investing.

India has lately taken baby steps towards Smart Beta ETFs, with both the NSE and BSE now offering an expanded menu of strategy indices and thematic indices that use strategies such as Value, Growth, Dividend Yield and so on to pick stocks. ETFs piggy-backing on these indices are also making a debut.

If Smart Beta ETFs become the norm, then they will prove far more difficult to beat than the old-fashioned bellwethers such as the Nifty or the Sensex.

That's when ETFs will gain clout in India; so active managers better watch out!

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