One of the major trends in the asset management industry currently is the relentless rise of exchange-traded funds (ETFs). ETFs now account for over a trillion dollars in assets, up from only about $75 billion in the year 2000. ETFs have gained huge popularity over the last decade as they can be used to gain exposure to a number of asset classes including equity, fixed income, commodities and currencies. They can also be used to gain exposure on either side of a trade, i.e. long or short as well as on a leveraged basis. ETFs have several advantages over index funds: In the types of asset classes covered and ability to short as well as their ability to offer intra-day liquidity, being traded on the secondary markets.
ETFs have now started becoming very popular in India as well, with over 25 per cent of all secondary market FII flows into India coming through this route in 2009 (about 15-20 per cent of total FII flows including primary market issuance, Credit Suisse estimate). Despite this accelerated flow through ETFs into India, single-country India ETFs are still extremely small compared to China or Brazil. Brazil single-country ETFs, for example, are almost seven times the size of India ETFs, giving a sense of how much bigger India ETFs can become. The difference in size is really because of the much later launch of these products for India due to historic regulatory issues. The cumulative flow into India from ETFs [both single-country and Emerging Market (EM)] is over $6 billion (source: Credit Suisse)till date, making it equivalent in absolute size to the largest country funds.
The reality today is that anyone trying to raise new money for either an India hedge fund or even a long only mutual fund, is faced with intense competition from the ETF. The sad truth is that over the last three years, very few funds have been able to outpace the benchmarks by enough of a margin to justify their fees. Most funds have also clustered around quite similar performance numbers, making differentiation for investors difficult. Many investors were also spooked by the illiquidity of non-index based stocks in India, when they tried to exit, and experienced significant price damage as their funds liquidated holdings to meet redemptions. Why not use a highly liquid, cheap and index-tracking instrument rather than bother about trying to figure out the small sub-section of managers who can truly beat their benchmarks in a sustained manner? This is a logical question being asked by more and more investors. Investors are also questioning the need to be in mid caps after the huge drawdowns and volatility of 2008-09 — so why not just be in index stocks? Play the macro country story, does one need to drill down and look at stock-specific alpha creation? I am pretty sure that a lot of asset allocators are using ETFs rather than investing through funds. It is one of the reasons that most India funds have received very little by way of new inflows through this rally. Just anecdotally in my own discussions with prospective investors, the use of ETFs seems to be destined to be far greater going forward than it has been in the past few years.
Another reason for the popularity of the ETFs, is the serious bruising most macro funds received in their attempt to exit India in 2008, when markets got crushed. Macro funds are by definition not stock-pickers, and are perfectly happy to play the index, rather than trying to get involved directly in specific stocks. For as they discovered, with the exception of a handful of index heavyweights, liquidity just vanishes for most equities in India when markets retreat. Macro funds are very active and on the margin, driving the global move away from dollar-based assets. ETFs are the perfect vehicle for a top down macro fund to execute its strategy seamlessly.
To me, it seems as if this trend towards ETFs will only accelerate, and I would not be surprised to see an even greater percentage of secondary market flows in 2010 come through this route compared to the 25 per cent we saw in 2009.
What are the implications of this trend coming to pass?
First of all, it will be interesting to see how the huge expected equity issuance of $30 billion in 2010 will get sold, if a large chunk of FII flows come in through the ETF route. ETFs do not buy QIPs or IPOs, and thus bankers may find that the major source of funding for new equity issuance comes from local institutions. One should be prepared to see many issues, wherein the anchor investors or the majority of the book are filed by local institutions. There is nothing negative in this, but it will probably mean a change of focus for the I-banker community and companies. Local investors will increasingly have to become the first port of call for any deal.
Secondly, as most Indian brokers will not be able to get the execution orders for these ETF flows, one may see a relative shift in market shares between local and international brokers. Since these trades are largely done as large programmes on very low commissions, the commission pool will also get compromised to a certain extent.
These flows will go into the large-cap liquid index stocks, thus pushing them even higher and creating a valuation cushion for the mid-caps to move up. In most sectors, the large-cap index stocks trade at a premium to the sector, as these valuations get pushed up even more because of blind index-based buying through the ETF route, space gets created for selected mid-caps to play catch up and have PE expansion of their own. The continued upwards valuation creep for the large-cap index stocks will also push more knowledgeable local investors into mid caps, as they are unable to justify to themselves the large valuation premiums of the index constituents. Ironically, just as ETFs have gained prominence due to the perceived inability of most funds to outperform their benchmark, their own popularity will create the valuation space to encourage and reward stock picking.
To the extent many macro funds are using the ETF route for EM exposure, and given their liquidity, this instrument does integrate India even further with global flows and trends. Any change in stance towards the EM equity asset class can be immediately expressed through these ETFs, and thus, a lot more asset allocation flows will enter and exit our markets and with greater velocity. We will become more exposed to top down macro themes.
ETF’s are here to stay and are now a legitimate part of any investor’s choice set when looking across asset classes and markets.
The author is founder and CEO of Amansa Capital. Views are personal
