In these times, there’s one investment idea that is steadily gaining attention. That’s passive investing, where one invests in an index — such as the Sensex or the Nifty 50 — to earn the same return that the index does. Within passive investing, Exchange Traded Funds or ETFs are gaining so smartly so that it’s perfectly possible to build a good, diversified portfolio with just ETFs.
But ETFs can be tricky investments if you don’t know how they are built or the factors to look out for. So, let’s dig in.
Why is it important to know about ETFs in the first place? For one, active mutual funds (MFs), i.e. those that aim to beat the market, are finding it increasingly hard to sustain higher returns, and several have been lagging benchmarks. Investing in indices lowers the impact of the fund’s underperformance on returns, and removes the need to keep note of performance to weed out poor funds and reinvest in good ones. Second, the ETF space is evolving. ETFs are now being built on indices with strategies, sector opportunities, and behaviour that are distinct from the plain-vanilla Nifty 50 or the Sensex or even mainstream MFs.
Low volatility, alpha, value-based, quality-based, private banks, target-maturity debt indices are some examples of differentiated strategies. New ETFs lined up for introduciton include indices built on growth sectors, electric vehicles, auto, manufacturing and new-age digital, to name a few. A well-rounded portfolio needs a mix of strategies and styles to capture different opportunities, to manage both downside containment and participation in rallies. Differentiated indices make great portfolio additions as they offer a return perspective that can complement your core mutual fund portfolio.
Three, some of these indices do not have an index MF variant. In many cases, even where there are index funds, they invest in the ETF itself and not directly in the index. That introduces an additional layer of expense for you; avoidable if you hold the ETF itself. There are more than 90 ETFs already available, spanning a range of indices in equity and debt, as well as global indices. Silver ETFs are on their way, too!
What they are
ETFs are introduced by asset management companies (AMCs). They pick the index to track and unveil a new fund offer (NFO) for the ETF. The amount collected in the offer is invested in the constituents of the index (or commodity) in the correct weights. The AMC breaks the ETF into units. Investors in the initial ETF launch will receive units. So far in the story, this is what an index MF also does.
From here, ETFs differ. The units are listed on stock exchanges, and subsequent investment or selling happens in these units only on the exchange. In other words, post an ETF’s introduction, you buy or sell ETFs like you’d buy or sell a share. You would need a demat account to invest in ETFs. Trading activity in these funds does not change their asset size.
That brings up the second aspect — market price. You know the net asset value (NAV) in an MF, which is the asset size divided by the number of units in the fund. An ETF also has an NAV as it still is a pooled investment broken down into units.
But the NAV is not the price at which you invest in an ETF — remember, you are buying or selling units on the stock exchange only and not with the AMC itself. So, you’ll be paying the market-determined price when investing in the ETF. The main factor that influences this price is the underlying index movement. In an ideal world, the market price will exactly track the index (less expenses, of course) and the underlying ETF NAV. But unfortunately, that’s not the reality. An ETF’s market price is additionally influenced by the demand for the ETF’s units and their supply.
To explain, if an ETF sees more buyers on the exchange and not enough sellers, its price moves up and vice versa. This can render the market price out of sync with the underlying index movement and the NAV — where the ETF will return much higher than the index or lower.
AMCs that manage their ETFs well will see to it that such supply-driven fluctuations are addressed by creating more units (by inviting large investors to invest directly in the ETF and increase its size and units) or managing market activity to ensure that price aberrations are corrected.
A key point to check in an ETF is how closely it tracks the index it is built on — i.e., how much the ETF’s returns deviate from the index’s returns, known as tracking error. Lower the error, better the ETF.
A large differential between the ETF NAV and its market price is a red flag and an indicator of potentially higher tracking error. Of course, 100% accuracy is not possible due to ETF costs. An ETF’s expense ratio can thus make a difference.
Keep an eye out
The next factor is trading volumes. Healthy volumes of at least a few crore rupees or several lakhs are good. This means it is easy for you to invest or sell any amount, and without such activity impacting the market price. Tracking errors also tend to be lower if volumes are healthy, though it is not a rule.
In a nutshell, ETFs are starting to offer new opportunities that can be good diversifiers in your portfolio. Keep note of this investment option!
(The author is Co-founder, PrimeInvestor.in)