Making ETF A Part Of Your Portfolio
Dalal Street Investment Journal|October 26, 2020
Why do exchange traded funds (ETFs) suffer from low investor participation even when they have generated better returns than index funds in the same period? The following report provides insights into the ETFs and how they function while pointing out their merits and demerits in terms of retail investing

September 2020 was the third month in a row when there was a net outflow from equity-dedicated mutual funds. During the same period, there were net inflows of more than 20,000 crore into exchange traded funds (ETFs) other than gold but including fixed income. The rise in asset under management (AUM) of ETFs has been even better. Healthy inflows along with gains in the equity market have led to increase in the AUM of ETFs. In fact, over the past two years ending September 2020, the AUM of ETFs has increased at an annual rate of 51 per cent.

The pace of growth of AUM in ETFs far exceeds the growth in AUM of equity mutual funds, which grew by a mere 6 per cent annually in the same period. There are a couple of reasons for ETFs to outpace growth in mutual funds. First, the base was small for the ETFs. At the end of June 2015, the total AUM under ETFs was merely 7,320 crore compared to the AUM of equity mutual funds of 3.7 lakh crore. Besides, institutional investors made a foray into ETFs only as late as in the year 2015. The acceleration in the growth of ETFs’ AUM began from 2015 when the Employees’ Provident Fund Organisation (EPFO) was allowed to take equity exposure. At present, the EPFO is only allowed to make equity investments through passively-managed ETFs.

The real pick-up in the AUM of ETFs therefore was observed only after this institution was allowed to invest. Besides, the government too started to offload its shares in state-owned enterprises through ETFs to meet the disinvestment target. Hence, from a mere 1 per cent of the total AUM of the domestic mutual fund industry, ETFs have now climbed up to almost 7 per cent of the total AUM. In terms of absolute growth they have grown 23 times in the last five years ending June 2020.

Low Participation of Retail Investors

However, despite such a growth curve, ETFs are yet to be embraced by retail investors. The penetration of ETFs still remains low among retail investors. At the end of June 2020 only 1.69 per cent of the total AUM was derived from retail investors while in terms of the number of folios, it accounted for 95.96 per cent. The share of AUM has come down from 9.95 per cent at the end of June 2015. The total AUM has slipped down in terms of percentage but has increased four times in absolute terms from 700 crore at the end of June 2015 to 3,000 crore at the end of June 2020.

There are some specific reasons why ETFs have a lower presence in a retail investor’s portfolio. A typical retail investor will decide how to invest by consulting an independent financial adviser. ETFs are not promoted by many financial advisors or distributors as they have fewer incentives to do so. They will not earn any trailing commission out of the investment an investor makes in ETFs. Mutual fund distributors play a big role in bringing in investments from retail investors. According to the latest data by industry body Association of Mutual Funds in India (AMFI), these distributors raked in more than 80 per cent of the total AUM of individual assets and hence play an important role in promoting products such as ETFs among retail investors.

Besides, for an investor who is only investing in mutual fund schemes, there will be the additional burden of opening a trading and dematerialisation account and maintaining it, which comes at a cost. Therefore, many retail investors opt for index funds instead of ETFs. In addition to these technicalities, we believe that lack of understanding and awareness of the product is also a prime reason for lower acceptance of ETFs by retail investors. Hence, we will try to clear the air around this product. Before that, however, we will check if it is a good investment in terms of returns.

Performance Comparison

Most of the index funds and ETFs follow a passive investment strategy where they try to replicate an index. In India, most of the ETFs and index funds have Nifty 50 or BSE Sensex as the benchmark. They account for almost 50 per cent of total ETF assets. As such, we have compared the returns generated by ETFs, index funds and their benchmarks. In the figure below we have compared returns of 26 ETFs and index funds benchmarked against Nifty 50 TRI for the last one year.

Origin of ETF

Very few people would know that the origin of ETFs can be traced back to the report by Securities and Exchange Commission (SEC), a US’ market regulator. The report titled ‘The October 1987 Market Break’ was an investigation about the Dow Jones Industrial Average’s steep fall of 508 points or 22 per cent in a single day on October 19, 1987, which till date remains the single biggest fall in terms of percentage for DJIA and is now better known as ‘Black Monday’. This 840-page report by SEC diagnosed ‘portfolio insurance’ as the reason for such a fall, which inadvertently suggested the product idea of ETF.

The report recommended an alternative approach where a well-capitalised and supplementary market-maker could have turned to a single product for trading baskets of stocks, which would have made the fall less drastic and smaller. The idea was picked up by the product development team of American Stock Exchange (AMEX), and that led to the first ever ETF in the US. The Standard & Poor’s Depository Receipts (SPDR) focused on investing in the Standard & Poor’s (S & P) 500 index, which till date remains the largest ETF in terms of (AUM). And as said, the rest is history!

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