Low-volatility ETF can be part of your core portfolio

But investors should wait until ICICI Pru's new smart-beta offering develops a track record

Smart-beta exchange-traded funds (ETFs) are gaining popularity globally with assets under management (AUM) worth $700 billion. ETFs based on market-cap weighted indices invest in stocks that have the largest market capitalisation, with the disadvantage that their valuations are already rich. Smart-beta indices, on the other hand, are based on fundamental investment parameters, such as dividend yield, earnings growth, valuation, etc. ICICI Prudential Mutual Fund recently launched a smart-beta product called ICICI Prudential Nifty Low Vol 30 iWin ETF. The low-volatility strategy is already popular abroad, with AUM of about $180 billion globally.

This ETF is based on the Nifty100 Low Volatility 30 Index. Thirty stocks with the least volatility (measured by standard deviation of returns over a one-year period) are chosen from the Nifty100 Index. These 30 stocks are weighted in terms of volatility: Lower a stock’s volatility, higher its weight in the index. The index is reviewed quarterly. It includes high-quality, large-cap names such as HDFC Bank, Hindustan Unilever, etc.  

According to Chintan Haria, fund manager and head-product and strategy, ICICI Prudential AMC: “This is a product which is likely to give better risk-adjusted returns than a market-cap weighted index, as demonstrated when back-tested over the past 10 years.” He adds that should the markets fall due to a sharp sell-off, this index is likely to correct less, given the presence of highly liquid, large-cap names.

This portfolio may, however, underperform when the markets witness a sharp rally, as in 2007. Investors investing in this ETF should also not do so in the belief that it will be immune to corrections. “Ultimately, it is an equity product that is going to be subject to market risks. It is just that the stocks in this index have a lower level of volatility than other stocks,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

Investors also need to be aware of the problem that arises from low trading volumes in ETFs, which can result in a significant spread between the NAV (net asset value) and the market price. If the spread is high, investors could be forced to sell at a significant discount to the NAV when exiting the ETF. How low the spread is will depend on the efficiency of market making in the ETF.

This ETF is being sold on the basis of back-tested data. “Investors need to see how the ETF performs after launch. The risk with back-tested data is that you may not get similar superior returns in all types of market conditions,” says Dhawan. As with all ETFs, this product will not allow you to do SIP (systematic investment plans) or STP (systematic transfer plan) — strategies that are important in overvalued markets.

ICICI Pru’s ETF has an expense ratio of 49 basis points. Regular ETFs based on the Nifty today have an expense ratio as low as 5-10 basis points, while direct plans of actively managed funds have an expense ratio of above 100 basis points. As the Indian market gets better researched, it may become harder for active fund managers to beat the indices, especially in the large-cap space. As returns come down, investors will focus more on costs. That is when they will want to move to smart-beta ETFs, say experts. 

This product, which has the potential for long-term, steady wealth creation, can be a part of an investor’s core portfolio. However, investors should wait until it has developed a track record of at least a couple of years and they can see the level of spread it has.