For low-cost and diversified exposure to an asset class, invest in an ETF

Choose the ones that have a low expense ratio but high trading volumes on the exchanges

The National Stock Exchange (NSE) announced recently that the asset under management (AUM) of Nifty 50 based exchange-traded funds (ETFs) has touched Rs 1 trillion. The AUM of all ETFs (equity and debt) has crossed Rs 2 trillion. Fund managers say they have witnessed rapid increase in the number of investors in ETFs this year, which indicates high interest from retail and high net worth individuals (HNIs) in these products.

Fewer choices to make: By taking exposure to an ETF, investors can circumvent the risk of investing in the wrong sectors and stocks. When the market fell towards the end of March, many of them would have struggled to gauge the impact. “In an uncertain environment where it is difficult to judge which sectors or stocks are going to get impacted or emerge, it makes sense to invest in a low-cost basket of blue-chip companies that make up a product like the Nifty ETF,” says Vishal Jain, head-exchange traded funds, Nippon Life India Asset Management.

ETFs are a good option for beginners as well. “They can get exposure to a diversified basket of stocks with only a small amount of money,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors. Newcomers also don’t need to decide which fund manager to go with.        

Growing market efficiency: The S&P Indices Versus Active (SPIVA) India scorecards, which evaluate the performance of actively-managed funds against their benchmarks, have demonstrated that large-cap fund managers, especially, are having a difficult time beating their benchmarks. The 2019 year-end report had the following numbers for large-cap funds: over a five-year period 82.9 per cent and over a 10-year period 64.8 per cent actively-managed funds failed to outperform their benchmarks. “In the light of such numbers, many investors today are gravitating towards passive products in the large-cap segment,” says Dhawan.

Cost advantage: The benefit of lower cost become more pronounced with time. If you pay just 5 basis points as expense ratio in a Nifty ETF, then over 10 years you pay 50 basis points to the AMC. On the other hand, in an actively managed fund, if the expense ratio is 1.25 per cent for a direct plan, you end up paying 12.5 per cent over 10 years. In a regular plan, if the expense ratio is 2.25 per cent per year, you end up paying 22.5 per cent over this period. These costs get deducted from the investor’s returns. With this kind of a cost differential, it is not easy for active funds to beat their passive peers.

Portfolio construction becomes easy: ETFs make it very easy to build diversified, asset-allocated portfolios. “It’s difficult to predict which asset class will move and when. So, it is extremely important that investors diversify across asset classes. ETFs offer a convenient way to take exposure to different asset classes in a simple and cost-efficient manner,” says Jain.

They can use ETFs based on indices like the Nifty 50 and Nifty Next 50 for large-cap exposure and something like a Midcap 150 Index to take exposure to the mid-cap segment. Conservative investors could take 75 per cent of their equity (50+25) exposure to the large-cap indices and 25 per cent to a midcap index. Aggressive investors (if and when they feel that midcaps have a good outlook) could have a heavier allocation to midcaps. The exact allocation to different segments would depend on the investor’s risk appetite.

Those who have adequate exposure to the Indian market and wish to diversify internationally can make use of ETFs based on indices like the Nasdaq, Hang Seng, etc. now available in India (with about 15-20 per cent of their equity exposure in these products). Gold ETFs may be considered by investors who wish to hedge their portfolios against equity-market risk and also want liquidity (it is easy to exit gold ETFs at any time, while a product like the sovereign gold bond, which gives an annual return of 2.5 per cent, is illiquid). They make 10-15 per cent exposure (of their total portfolio) to gold ETFs.

Investors can also use a core and satellite approach to build their portfolios. A large-cap ETF (like one based on the Nifty 50) could make up the core portfolio. This will ensure that the investor gets market-equivalent return over the long-term. In the satellite portfolio, he could have products (say, midcap ETF or mid- and small-cap active funds) through which he could take higher risks in anticipation of higher returns. Dhawan is of the view that investors should at this point use an ETF for their large-cap exposure while continuing to use active funds in the mid- and small-cap segment, where fund managers still seem to have scope for outperformance.

Most advisors at this point seem to prefer the Nifty 50 based ETFs over the Sensex-based ones. The former has 50 stocks and hence is more diversified than the latter which has 30 stocks. Also, there is an active market in Nifty Futures. Volumes on this instrument are large, which makes it easy for market makers to generate liquidity in a Nifty 50 ETF. 

Next, let us examine the three main criteria investors need to take into account while selecting an ETF.

Expense ratio: Since ETFs are commoditised products, cost should be an important consideration. “When investing in ETFs, be very conscious about cost. Buy a low-cost ETF through a discount broker who charges a very low or zero brokerage fee so that the total cost of an ETF is less than on a similar index fund,” says Avinash Luthria, a Sebi-registered investment advisor and founder, Fiduciaries.

Liquidity: Besides low cost, investors need to give equal, or perhaps even greater, weight to liquidity. Purchase one that is more liquid. An ETF’s liquidity can be evaluated by tracking the trading volume data on the stock exchanges. Also, NSE publishes the impact cost of ETFs. An ETF with a lower impact cost is more liquid.  

Luthria says liquidity is an extremely important criterion. “Suppose that an ETF’s NAV is Rs 100. If it is illiquid, you could end up buying at Rs 102 or Rs 103. And at the time you exit, you could end up selling at Rs 98 or Rs 99. Any advantage that you may have gained by investing in a low-cost ETF could be lost due to poor liquidity,” he says.      

Tracking error: This refers to how closely the ETF tracks the index. An ETF with a lower tracking error is regarded as being better managed. If the tracking error is high, the index could move up but the ETF may lag behind, thereby impacting the investor’s return.

A few points to remember: Many investors harbour the misconception believe that just because ETFs are listed on the stock exchanges, they should be treated as trading instruments. “For wealth creation, treat ETFs as long-term investment instruments that give you broad-based equity exposure. Avoid trading in them,” says Dhawan.

Avoid investing in an ETF on the basis of past performance alone. Also keep in mind asset allocation and valuations. The Nasdaq 100 ETF and gold ETFs, for instance, have given strong returns this year. If their allocation in your portfolio exceeds the original level, rebalance. Finally, invest at regular intervals even in an ETF instead of putting in lump-sum amounts. Those who want the discipline that systematic investment plans (SIPs) bring to the investment process may consider index funds.