Buy debt ETF for low-cost advantage, but ensure that portfolio is liquid

Edelweiss Mutual Fund emerged as the front runner in the recently held bid to manage the government’s debt exchange-traded fund (ETF). This ETF will hold bonds issued by central public sector enterprises. A few ETFs already exist in the debt category. One is the LIC G-Sec Long-term ETF, which holds long-term government securities. Reliance, ICICI Prudential and DSP offer ETFs in the liquid category. The forthcoming ETF will be the first to hold corporate bonds.  

Diversification benefit: A debt ETF offers the advantage of diversification. Instead of being exposed to a single security, as happens when the investor invests in an instrument like a non-convertible debenture (NCD), he is able to get exposure to a basket of securities, which reduces risk. 

ETFs also offer the advantage of low cost. Their expense ratios are much lower than that of actively-managed funds. While the expense ratios of the existing debt ETFs range from 0.28-0.65 per cent (average 0.49 per cent), those of medium-duration debt funds (regular plans) range from 0.78-2.01 per cent (average 1.41 per cent).   

   

ETFs also offer greater price flexibility. An investor can buy or sell them any time during the trading hours. In a fund, the net asset value (NAV) is decided only at the end of the day and units are allotted then.  

ETFs offer a steady-state investment option. For instance, if it’s an ETF that holds 10-year bonds, the investor knows the portfolio and understands how it will behave. “In an actively managed debt fund, you do not know what the fund manager’s duration calls will be. In a passive fund, say, one with a constant-duration mandate, the duration will not change. Such an instrument can be useful for a buy-and-hold kind of investor, in the sort of environment where the direction of interest rate is hard to predict, as was the case in 2018,” says Kaustubh Belapurkar, director-manager research, Morning-star Investment Adviser India. 

Liquidity risk: The key risk that experts see in a debt ETF pertains to liquidity. The corporate bond market in India is not very liquid, especially for lower-rated instruments. In the ETF market, there are players called authorised participants (APs) who create and redeem units. When there is demand for the ETF, they put together a basket of securities (the same securities and in the exact weight) and give it to the fund house managing the ETF, which in turn hands them units of the ETF. When demand falls, they do the opposite. Through their activities, they ensure that the traded price of the ETF does not deviate significantly from its NAV. “APs can only carry out their task efficiently if the underlying bonds from which the ETF is constituted are liquid. If they are not, the ETF’s traded price could deviate significantly from the NAV, and APs will not be able to do anything about it,” says Ramabhadran Thirumalai, assistant professor of Finance at Indian School of Business. Adds Belapurkar: “For retail investors who typically buy and sell small lots, the price they pay or get may not be the most efficient.” They could end up buying the ETF at a higher price and selling it at a lower price (vis-à-vis the NAV). 

A debt ETF will follow the passive investment approach, as described above. There will be no fund manager to reduce the average maturity in a rising interest-rate scenario and increase it in a falling rate scenario. “This means that the NAV of the debt ETF will rise and fall with the market,” says Joseph Thomas, head–research, Wealth Management, Emkay Global Financial Services. 

Tracking error should not be high: Before you invest in a debt ETF, check its tracking error. This is the divergence between the price of an ETF and the price of its benchmark index. The lower the tracking error, the better. “If the debt securities that the ETF invests in are illiquid, its tracking error will be high,” says Vidya Bala, head of research, Fundsindia.com. She suggests that if liquidity is an issue in an ETF, retail investors are better off investing in an actively managed debt fund, whose units they can sell to the fund house anytime they want and get paid the NAV. 

Investors should also study a debt ETF’s portfolio carefully. This will give them a sense of the level of yield it will offer. “Look at the average maturity of the bonds in the underlying portfolio of the ETF. This will give you an idea of the potential duration of the product and subsequent volatility,” says Dwijendra Srivastava, chief investment officer-fixed income, Sundaram Mutual Fund. If, for instance, the ETF is made up of longer-duration bonds, it will have more interest-rate volatility. Investors should only opt for such an ETF if they have a suitably long investment horizon. Thirumalai suggests that investors should check the ratings of the bonds in the portfolio. While a debt ETF comprised of PSU bonds is not expected to carry default risk,  a lower rating could result in lower liquidity.