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The rise of ETFs

Exchange-traded funds have started to gain traction in India. Here's how you can pick one

The rise of ETFs

Achieving significant growth and several milestones, exchange-traded funds (ETFs) are steadily strengthening their foothold in the mutual fund industry. Since actively managed funds - especially large caps - have been struggling to beat their respective benchmarks for quite some time, these funds have been able to catch investors' attention.

An ETF is a diversified basket of securities that track a particular index and is traded on an exchange in real time, like an individual stock. Also, like any other stock, an ETF can be bought and sold throughout the trading day. In the Indian market, the first ETF was launched by Benchmark Mutual Fund in December 2001 and it tracked the Nifty 50 Index. So, the concept of ETFs is not new in the market. However, they have gained popularity recently.

Over the last five years, while the assets managed by equity mutual funds have grown at a rate of over 20 per cent per annum, equity ETFs - in spite of having a smaller base - have witnessed a massive growth of over 89 per cent year on year. The graph titled 'Gaining momentum' shows the year-on-year growth rate of assets managed by ETFs as against those managed by actively managed equity funds.

In August this year, assets managed by the ETFs tracking the Nifty 50 Index crossed the milestone of Rs 1 lakh crore, while the total assets managed by all ETFs stood at over Rs 2 lakh crore. Although investing in ETFs is still at a nascent stage in India, it is gaining notable momentum on the back of several facts, including:

Government's involvement: ETFs came to the forefront in 2014 when the government took the ETF route (CPSE ETF) for disinvestment. Again since 2015, the Employees' Provident Fund Organisation (EPFO) has been increasing its stake in ETFs. All these factors led to the growth of Indian equity ETFs.

However, since EPFO mainly invests in one to two ETFs, one can clearly see the skewness in assets managed by ETFs. The top three ETFs manage about 70 per cent of the total assets managed by all equity ETFs.

Underperformance of active mutual funds: With the majority of equity mutual funds underperforming as against their respective benchmarks, the debate on active vs. passive funds has been raging for a few years. Therefore, investors have been moving to low-cost alternatives, such as the index funds and ETFs, in order to earn higher returns.

The ETF universe
As of September 2020, the Indian market had 93 ETFs across various asset classes. Equity ETFs are the most popular and manage assets of over Rs 1.74 lakh crore across 73 schemes. These are followed by debt ETFs that manage assets of over Rs 30,500 crore and gold ETFs with an AUM of over Rs 13,400 crore.

Amongst the equity ETF universe, a few categories have wider acceptance than others (see the graph 'Concentrated presence'). For instance, large-cap ETFs manage assets of over Rs 1.46 lakh crore, accounting for 84 per cent of the total assets managed by all equity ETFs. There are two main reasons why some particular categories of equity ETFs are more popular than others:

  • Although the concept of ETFs has been there for quite some time, these funds have recently started gaining investors' interest. Quite obviously, the universe of this category is confined, with limited flows into some particular categories. However, with an increase in the participation of retail investors, the industry is likely to come up with more product variants and more categories are likely to gain investors' favour.
  • Another major issue faced by ETFs is that these funds can replicate an index based on the liquidity of underlying stocks. Since only the stocks in broad-based indices tend to be liquid, ETFs have mainly been limited to broad indices. Some large-cap indices, such as the Nifty and Sensex, have highly liquid stocks. So, they can support large-size ETFs and easily deploy the additional money on a day-to-day basis. But as we go down the market cap, replicating the indices gets challenging as their underlying stocks are not highly liquid.

Selecting the right ETF
Since ETFs are passive products that track the index, there is not much difference in the portfolios of two ETFs tracking the same category and index. So, when it comes to choosing the right ETF, investors should consider the following factors:

Expenses: It should be the first consideration. The low-cost feature of ETFs has made these funds more popular than their actively managed counterparts. So, make sure that you are not paying much for your ETFs.

Tracking error: The entire success of ETFs hinges on how efficiently they manage to replicate the index. The difference between the returns of an index and an ETF is captured by the tracking error of the fund. Hence, go for funds with low tracking error.

Liquidity: When it comes to investing in an ETF, it is equally important to exit it as and when required. So, as a retail investor, it is important for you to ensure that ETFs have enough liquidity. Therefore, you must check whether or not an ETF trades on the exchange daily with a fairly high trading volume.

Price and NAV difference: Make sure that the prices at which ETFs trade are closely aligned with their NAVs. Usually, when checked on a daily basis, there is little difference between these two. Nevertheless, several factors, including the demand for ETFs, may widen the difference, which can hurt the interests of investors as they will end up investing at very high prices.

An ETF that largely meets all the aforesaid criteria should be the ideal choice.