While awareness about exchange traded funds (ETFs) is quite low in India, these funds are gaining currency with investors over the last few years. In the last 5 years, the mutual fund industry assets under management (AUM) in ETFs have grown at a CAGR of more than 100%. In FY 2018 alone, the ETF AUM grew by more than 64% on a year on year basis. But ETF AUM still constitutes a fairly low percentage industry wide equity AUM in India – ETF AUM was only about 10% of industry wide equity AUM in FY 2018. In the developed markets, however, ETFs and index funds are hugely popular with investors. In this blog post, we will discuss about ETFs, so that investors can make informed decisions with regards to whether these funds can be suitable for their investment needs.
Exchange traded funds are passive schemes, which aim to track a particular market index like Sensex, Nifty, BSE – 100, Nifty – 100 etc. ETFs invest in a basket of stocks which replicate the index ETF aims to track. ETFs do not aim to beat the index like actively managed mutual fund schemes; they aim to minimize the tracking error. Tracking error is difference in returns of the ETF and that of the index. When investing in ETF you should expect to get the index returns, nothing more and nothing less.
The hassle of opening a demat account with a stock broker puts off many investors who may have wanted to invest in ETFs. Fortunately, mutual funds offer “ETF like” investment products where you can invest in a passive fund which tracks an index, without having a demat account. Index funds are mutual fund schemes which aim to track a particular index like Sensex, Nifty, BSE – 100, Nifty 100, Bank Nifty etc. The fundamental attributes of index funds are exactly like ETFs, while the investment process (buying and redemption) is just like any other mutual fund scheme. The expense ratios of index funds are slightly higher than ETFs but much lower than actively managed funds – expense ratios of index funds can be 2 – 2.25% lower than actively managed funds. As such, index funds are excellent investment options for investors, who want to remain invested for long periods of time, but do not have the time or effort to monitor fund performance on a regular basis.
A few years back, the legendary investor, Warren Buffett advised his own family to put his wealth in index funds after he is gone – such is his conviction that index funds will beat actively managed funds in the long term. His belief is not without basis – more than 90% of large cap companies in the US failed to beat the S&P 500 index over long investment tenor. There is also a theoretical foundation for Buffett’s belief – the Efficient Market Hypothesis.
In an efficient market all publicly available information is already factored in share prices. The corollary of this hypothesis is that if all information is priced in, then one investor does not have an edge over another investor. Market is a collection of all investors and therefore, extending the Efficient Market Hypothesis, it is not possible for an actively managed fund to beat the market. In 2007, Warren Buffett announced a $1 million bet that in 10 years S&P 500 index funds will beat actively managed funds. In December 2017, Buffett won the bet.
Assuming the validity of Efficient Market Hypothesis, Buffett’s bet shows that the US stock market is highly efficient, but can the same be said about our market? Refer to our tool, Mutual Fund Category Monitor. You will see that average actively managed mutual funds were able to beat both average index funds and ETFs over the last 10 years. This shows that there are pricing inefficiencies in our market, which fund managers are able to exploit and generate alphas for investors. There were major reforms in our stock market in the late 90s and 2000s, aimed at correcting structural deficiencies and making our market efficient. However, compared to markets in the US and other developed economies, our market is far from being efficient - fund managers in India can continue to generate alphas for investors in the future as well. As our market becomes more and more efficient, the alpha generating opportunities will narrow.
If you look at the last 1 year, index funds have beaten most equity mutual fund categories. This may simply be due to market conditions which favored large cap, but the interesting point here is that index funds were able to beat large cap equity mutual funds. In the long term, the performance differential between actively managed funds and index funds will narrow. Like in the US now, index funds will become very popular in India in the future.
In this blog post, we discussed about Exchange Traded Funds (ETFs) and Index Funds. These are excellent investment options for passive investors, who want to beat inflation and get good returns over a long investment horizon. Actively managed funds will continue to form the major part of investment portfolios, but ETFs and index funds will gain an increasing share of wallet over time. There are pros and cons of investing in ETFs and index funds, which we have discussed in this post. Investors should educate themselves about ETFs and index funds, so that they can take informed investment decisions.
Disclaimer: The views expressed herein are based on internal data, publicly available information and other sources believed to be reliable. Any calculations made are approximations, meant as guidelines only, which you must confirm before relying on them. The information contained in this document is for general purposes only. The document is given in summary form and does not purport to be complete. The document does not have regard to specific investment objectives, financial situation and the particular needs of any specific person who may receive this document. The information / data herein alone are not sufficient and should not be used for the development or implementation of an investment strategy. The statements contained herein are based on our current views and involve known and unknown risk and uncertainties that could cause actual results, performance or event to differ materially from those expressed or implied in such statements. Past performance may or may not be sustained in the future. LIC Mutual Fund Asset Management Ltd. / LIC Mutual Fund is not guaranteeing / offering / communicating any indicative yield on investment made in the scheme(s). Neither LIC Mutual Fund Asset Management Ltd. and LIC Mutual Fund (the Fund) nor any person connected with them, accepts any liability arising from the use of this document. The recipients(s) before acting on any information herein should make his/her/their own investigation and seek appropriate professional advice and shall alone be fully responsible / liable for any decision taken on the basis of information contained herein.
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