14OCTOBER 2010 | FINANCIAL PLANNING JOURNAL |

Exchange traded Funds – A route to efficient investing

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15OCTOBER 2010 | FINANCIAL PLANNING JOURNAL |

in the present scenario, with the rise of EtFs, and with its ability to provide for higher efficiencies in comparison to the traditional routes for capital market investing, it is important for Financial planners to give it a due consideration, in line with the client needs.

Amar RanuSenior Manager, Third Party Products-Research Motilal Oswal Securities Limited

The Efficient Market Hypothesis (EMH) explains that stock markets are more efficient and less predictable. The strong form version of the EMH states that stock

prices reflect all information relevant to the firm, including even information available only to the key management or company insiders. This led to the conclusion that fund managers have been finding difficult to beat the benchmarks over a longer period as major stocks have been valued fairly with the currently available information. So, active funds have been losing its money in terms of increased costs. This probably led to the global fund managers to move towards a product, a fund having multiple benefits such as low costs, liquidity, fund managers’ minimum intervention, diversified portfolio, tax benefits etc. Thus, the whole world moved to the invention of Exchange Traded Funds, popularly known as ETFs. Call its charismatic performance or its efficiency, ETFs emerged as the most traded shares in US surpassing the most active stocks in terms of volume.

As per the book, Inconvenient Truths, authored by Larry E. Swedroe, it makes a strong case for passive investing and against actively managed funds. On an average, actively-managed funds in US have underperformed their benchmarks on a per-tax basis. On a post-tax basis, their returns are even poorer.

What are ETFs?Exchange Traded Funds are essentially open ended funds

that are listed and traded on exchanges like stocks. They enable investors to gain broad exposure to indices or defined underlying assets with relative ease, on a real time basis, and at a lower cost than many other forms of investing. It invests in the constituents of the index in the same proportion as the index and come with the feel of the index. They are largely passive in their investment strategy and their returns are more or less in line with the returns in the index. ETFs have got a lot of benefits including low cost structure, tax efficient, transparent portfolios etc.

Why ETFs?If investors are looking to diversify their investments,

hedge against risk, or take a call in a particular sector, ETFs can be the best option for them. Investors can take advantage of ETFs which are outlined below:

Cost-Effectiveness –• Since there is only one transaction per trade, commissions are lower on an ETF as opposed to an index. Absence of entry and exit loads also helps to keep the cost lower.Taxes –• Capital gain taxes are generally lower for ETFs than traditional mutual funds due to the structure.Flexibility –• Like an Equity, ETFs trade throughout market hours. ETFs can be sold short or on margin, and prices are continuously updated during the trading day. Passive Management –• ETFs are meant to follow a particular index, not to outperform it. Therefore it helps to keep the risk and management fees for ETFs low. Single Transaction –• ETFs act like indexes and follow certain market sectors. However, unlike an index, one can purchase an ETF with one single transaction.

Global JourneyETFs have travelled a long distance since its inception

in 1993 in USA. It took 7 years (from 1993 – 2000) to get it widely accepted among investors. Once it drew attention from investors, it grew leap and bound; the global ETF assets has reached an all time high of US $1.03 trillion as on March 2010 from an estimated US $463 million in 1993, clocking a CAGR of 56 per cent. On US Exchanges, 11 out of top 25 volume leaders/stocks are ETFs. Some of the top volume leader ETFs is SPDRs, iShares MSCI Brazil Index, Ultra Short Russel 2000 ProShares, etc. These ETFs account for 78 per cent of total volume out of top 25 traded stocks on US Stock Exchanges. It should be noted that the share of ETFs in the total volumes was less than 25 per cent 10 years back.

Indian JourneyETFs are not very old in India. It started its journey in 2001

after Benchmark AMC forayed into this unique proposition. Since then, the ETFs grew by leap and bound. The domestic ETF assets grew from R 7 crore in 2001 to R 3,203 crore

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16OCTOBER 2010 | FINANCIAL PLANNING JOURNAL |

as on May 31, 2010. However, the main course of action in ETFs got intensified in the recent bull period. Indian equities component of Global Emerging Markets ETFs account for US $ 5.5 billion of AUM while the domestic equity ETFs now account for US $ 0.5 billion. Overall, over the past year, around 20 per cent of the net inflows into the Indian market have come from ETFs, thereby, ETFs a very significant component of Indian fund flows. Table 1 describes the holdings of major India focused ETFs listed outside India.

Even in India, ETFs have grown by leap and bound in last 10 years. In a surprise move, the industry has been moving towards ETFs in a more energetic way and moreover, ETFs have been getting wider acceptance from all class of investors.

Table 2 mentions of Total Assets under ETF categories in India. It shows that it has dramatically increased its figures over a period of time.

Are ETFs good for investors?The global historical data suggests that the fund managers

have not been able to beat the benchmarks constantly over a longer period. In efficient market scenario, the active funds find difficulty in beating their benchmarks. So, it is always

preferable for investors to look for a product which provide a decent return, at least comparable to its benchmark with bounty of other benefits such as tax efficiency, low expense ratios.

ETFs are pools of stocks, bonds or in a few instances other types of investments such as Gold that you can trade like stocks. ETFs tend to have very low annual expenses – much lower than the actively managed funds. Moreover, ETFs are high tax efficient i.e. they tend to minimize distributions, which help in making the post-tax returns more efficient. ETFs are listed on stock exchanges and can be bought and sold like any other company share.

Product InnovationsInnovation is the key to success. At present all ETFs

are an index fund which mirrors an index or a benchmark, unlike actively managed funds whose managers try to beat the market. There have been talk of companies bringing out actively managed ETFs, but so at least in India, it has not been manufactured. Currently, in India, the underlying for ETFs are Index, Sector, Money Market Instruments, Arbitrage etc. In the recent times actively managed ETFs have also been launched, which have also added to the innovations. While passively-managed ETFs follow and mirror their index, actively-managed ETFs follow their own fundamentally defined rules.

Recent Developments in ETFsBenchmark Mutual Fund, the pioneer in setting up ETFs

in India recently filed an Offer Document with Securities and Exchange Board of India (SEBI) for the launch of six open-ended exchange traded funds. All of the planned launches are sector-specific.

The launch of so many ETFs points to the asset management company’s (AMC’s) confidence in the growing maturity of Indian investors. They are obviously of the view that investors now appreciate the advantages of investing via an index-based fund, and that passive investing might finally be coming of age in the country.

ETFs-An understanding for Financial Planners

ETFs provide an opportunity to investors with small corpus and limited knowledge to enter the market more efficiently. Historically, all the indices gave positive returns over a period of time and these returns have been higher than Fixed Income Instruments. While Gold ETFs provide a good opportunity for taking exposures in Gold, Financial Planners must spread the knowledge and benefits of Gold ETFs in terms of lower costs, tax benefits and others. Moreover, Financial Planners must stick on with the comprehensive and life-cycle financial planning services for retail clients through ETFs.

amarranu@yahoo.com

The author works as Senior Manager – Third Party Products Research with a leading financial conglomerate. Views given here are personal.

Table 2 : Total Assets under ETFs

Monthgold EtFs other EtFs

in R Crs.

31/08/2010 2639 (9) 1427 (15)

30/06/2010 1939 (7) 1135 (14)

30/04/2010 1711 (7) 1271 (14)

28/02/2010 1583 (6) 1342 (12)

31/12/2009 1352(6) 1031 (12)

31/10/2009 1085 (6) 868 (12)

31/08/2009 904 (6) 831 (12)

30/06/2009 844 (6) 898 (12)

30/04/2009 717 (5) 627 (12)

28/02/2009 781 (5) 808 (11)

Source : AmFI, Figures in bracket represent no. of schemes

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