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ETFs Keep it Simple

ETFs lack awareness which results in the fear of the unknown, hence investors do not go for them, says Rajan Mehta, Executive Director, Benchmark AMC

Rajan Mehta has over 16 years of experience in international and Indian financial markets. Rajan holds a degree in master of management studies from University of Bombay and did a post-graduate programme in investment management from the London Business School. Excerpts from an interview:

Do you think exchange traded funds (ETF), as a concept, is still ahead of its time in India?
We don't think so. A decision to invest in ETF is much simpler compared to investing in a stock or actively-managed mutual fund. So in terms of investor preparedness, ETFs shall come before direct stock investments and active mutual funds. By investing in a broad market ETF, one is buying market and hence one needs to have a view about only the direction of broad market and nothing else. While buying a single stock, one has to analyse the stock, management quality, future prospects and current valuation.

Today, millions of investors are investing in stocks and mutual funds, which demonstrate their ability and preparedness to take complicated decisions. There is no reason why they should find it difficult to invest in ETFs.

What ETFs lack is awareness which results in the fear of unknown and hence investors do not opt for them. Creating awareness in large and fragmented markets like India is a mammoth task but we are confident that we will be able to achieve it over a period of time.

Despite the ease of investing and exiting as well as lower costs, ETFs have not picked up. What are the reasons?
ETFs are one of the latest financial innovations introduced only during 1993. Any new concept takes time to be known widely. Globally it took more then five to seven years before it could be of any significant size. In India, it was introduced five years ago with Rs 21 crore in size. Even though it is still a fraction of the mutual fund industry, it has come far with more than Rs 700 crore in size with six ETFs.

Other major reason for ETFs growing slower then their potential is misfit of ETF into revenue models of many distributors. As for selling ETF, the fund house does not pay any upfront commissions or trail commissions to the distributors. Many distributors focus attention to high-margin products where there is significant upfront commission paid by the fund houses.

Globally, ETFs are used as preferred instruments by fee-based financial advisors who recommend least cost and efficient instruments to their clients. This model is good for investors as it brings transparency in the charges they are paying and for the advisors it avoids conflict of interest. In India, we are seeing slow but steady increase in such advisors as markets matures and evolve. This definitely augurs well for ETFs.

How relevant are index funds in the Indian context when majority of the actively- managed ones comfortably beat the indices?
All mutual funds have to statutorily mention that 'past performance is not an indication of future returns'. The regulators are asking mutual funds to write this not for the sake of writing but this has been proven correct time and again and they want investors to be aware. Same is the case of out-performance of active fund managers. Past out-performance is not indication of future out-performance.

Instead of our judgment getting clouded by past performance, it may be worthwhile to understand how indexing works and how it is more relevant today.

Mathematically, indexing should provide average return of all active investors in the market, assuming all stocks available are in the index. So practically indexing does better than all active investors when one takes into account the costs like higher management fees and transaction related charges incurred by active investors. Active investors include the broad spectrum from small retail investors investing in direct equity to highly professional investors like mutual funds and FIIs. Over a period of time, composition of these active investors is changing and the number of sophisticated investors is increasing.

This change in composition increases competition for good investment ideas and makes price discovery more efficient. This makes it more difficult for sophisticated investors to outperform index.

Let us assume that active management is like travelling in Mumbai by road and indexing is like travelling in Mumbai by local train. Different types of active investors can be compared with different types of road travellers which include pedestrians, cyclists, motorcyclists and travellers with fast cars. In early seventies, very few people had cars. So even if average time of all road travellers to suburbs could have been same but cars would have been consistently traveling faster than local trains and other road travellers like pedestrians, cyclists etc due to empty roads.

Compare this with today's scenario. Number of cars has shot up. This results in slower traffic and often cars reach later then local train. In addition to increase in number of cars, the sizes of cars have also increased. Some of them have even close to become commercial vehicles. This makes it even more difficult to navigate. In our context this is same as having higher number of professional fund managers and larger fund sizes. Increased corporate governance norms like disclosing results and earning guidance to entire market at same time and insider trading regulations are like introduction of more traffic signals. This again reduces speed, that means chances of out-performance.

Thus we believe that our markets are becoming more institutionalised and professional and hence more efficient. Thus the environment for indexing is being created.

What is the value addition of a fund manager in management of an ETF?
A fund manager ensures that the basket of securities tracks the indices very closely and all the changes in the indices are done in line with the changes in funds. This may sound easy but to do this with precision in real time involves a lot of skill and technology. The extra bit in managing ETFs is to have system set up to calculate and disseminate various things like creation/redemption baskets, cash components and also real time indicative NAVs. All these require high involvement of technology, systems and processes which are quite different than normal mutual funds. Creation and redemption also require seamless system with fund house, custodians, registrars, depositories and exchange.

At a time when other fund houses are mopping up huge amounts, Benchmark is getting left far behind. Moreover, assets of funds like Banking BeES have seen wild fluctuations. Do these things bother you?
We closed financial year 2006 with over 100% AUM growth. We also had our first profitable year so we feel that we have not done that bad. We have plans to increase awareness on ETFs and introduce more products which can give investors more choice. What is important is that this growth is coming mainly from ongoing sales rather then huge mop ups in NFOs. Bulk of the mop-up of industry has been through NFOs, which used NFO expense amortisation rule to the detriment of long-term investors and played on euphoria of NFO. This clearly did not agree with our philosophy and we kept clear of it. It might appear that we have lost out. But we are quite clear that only by doing the right thing we would like to achieve our goals.

First, the fluctuation of assets in ETFs and in actively-managed funds has different connotations. An investor who invests in an active fund is investing in the management prowess of the fund manager and hence the fluctuation in AUM of an active fund to a limited extent can be attributed to the vote of confidence in the ability of the fund manger.

Investors invest in the ETF because it is a convenient and a low-cost way to take exposure in relevant index. Investors make their own decision to enter or exit ETF based on their own views of market levels, their own profit targets etc. If an investor is bearish then there is no point for him/her to remain invested in an ETF. Apart from that, ETFs are also used to equities cash. This means that initially an investor uses ETFs to take market exposure to invest flows and then gradually divest ETFs in favour of some stock ideas. This also creates fluctuations in AUMs of ETFs.

Second, in an open-ended fund, asset fluctuations can play havoc with long-term investors as they subsidise transaction cost of short-term traders. While in ETFs, the investor who enters the fund or exits pays all transaction costs to the last paisa and no cost is born by long-term investors. This is one of the main reasons why ETFs are becoming fund structure of choice for many smart and prudent investors for their long-term investments as well as short-term investments.

Third, such large two-way flows have established robustness of our investments and operations infrastructure, which handled all of them very smoothly and vindicated the confidence reposed in us by our investors.

What is the rationale behind Split Capital Fund? Who are the targeted investors for Plan A and Plan B of the fund?
The rationale behind the Split Capital Fund is a mutual fund structure which can allow transfer of market risk from one class of investor to other class of investor. Class A was targeted to risk-averse investor who would like the upside of market without downside risk while Class B was targeted at a professional investor who can understand risk and assume risk of Class A investor at some price. Class A was like insurance buyer and class B was like insurance seller. Since the structure ensured that during the worst-case scenario of Nifty index reaching zero it will have enough money to pay off contractual obligation to Class A investors it eliminated any credit risk on class B investor which is normally the case when one buys insurance or was the case in earlier guaranteed return schemes offered by public sector mutual funds.

What is the road ahead for Benchmark and are there any products in the pipeline?
We have approval to launch nine sector ETFs and also plan to launch Gold ETF after regulatory approval. We have also filed offer documents for currency funds and inverse index funds.

Any words of wisdom for the investors?
While building long-term investment portfolio, annual cost is a very important factor. For short term, it does not matter that much. It is like when you are shooting from point blank range it does not matter if your aim is not that good but if you firing from long range, a deviation of a fraction of degree can lead to missing targets by meters. Same is the case with annual expenses for long-term investments. A few basis point increase in cost can result final portfolio less by even tens of percentage points due to power of compounding. Moreover, for long-term investments, one should make sure that investment is done in stable and long-term concepts rather than on flavour-of-the-month investment themes and fund managers.