Despite mergers and acquisitions having taken place regularly in the Rs 6.75 trillion Indian mutual find (MF) industry over the past decade, there was something unusual about Goldman Sachs Asset Management Co. Ltd’s acquisition of Benchmark Asset Management Co. Ltd. Launched in June 2001, the 10-years-plus fund house, with assets of Rs 2,935 crore, was India’s first fund house to focus mainly on passive schemes, especially exchange-traded funds (ETF). Launched with good intentions—to avoid fund manager’s risk and offering a low-cost option to investors—Benchmark AMC remained largely one of India’s smallest fund houses till date; ranked No. 26 out of 41 fund houses, in terms of its assets under management. Eventually, they got sold out. While poor distribution network and sponsor’s disinterest are the whispers on the street, the question most investors are asking is: Do exchange-traded funds (ETFs) work in India? And can stand-alone ETF fund houses work in India?
What are ETFs
ETFs are passively managed schemes that invest their entire corpus in a basket of securities, such as equity shares. They are not meant to outperform their benchmark indices; they are supposed to track it passively. Since fund managers are not involved in managing these funds—they work on an automated mechanism—these funds are meant for those who like to avoid the fund manager’s risk. However, unlike index funds (also passively managed) that work like any other MF scheme and buys and sell securities from the stock exchange, ETFs have a different mechanism.
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The fund house appoints market makers in the stock market who buy the basket of securities (such as all the scrips of the market index on which, say, an equity-oriented ETF is based upon) and hand it over to the fund house, in exchange of a certain number of units. This process is called unit creation, whereby ETF units are “created” in exchange of a basket of securities. The market maker then breaks up these units and sells them separately on the stock exchange. Investors can then buy and sell these units from the stock exchange.
For instance, according to the offer document of Benchmark Nifty BeES, India’s first ETF, you need to “create” a minimum lot of 10,000 Benchmark Nifty BeES units, at any point in time. At Thursday’s value, the total cost of this basket comes to about Rs 55 lakh (10,000 units multiplied by Rs 550 or one-tenth of Nifty’s value as on 24 March). This basket will contain all the 50 Nifty shares in exactly the same proportion as they lie in the Nifty, plus a small amount of cash, as mentioned in the scheme’s offer document. When the market-maker wants to redeem these units with the fund house, it does not get cash in return. It gets the basket of securities back.
Why are ETFs superior to index funds…
Since a passive fund, such as an index fund or ETF, tracks the market passively, you would expect it to give the same returns as that of its benchmark index. In reality, they don’t. The difference, called the tracking error, is caused because of the cash component that an index funds holds, and also when the fund manager buys and sells the stocks (to align with the underlying index) and pays brokerage on them. The fund’s expense ratio (they can charge a maximum of 1.5% a year) also adds to the tracking error.
But here’s why an ETF’s structure is superior to that of the index fund. Though your index fund manager is typically mandated to hold at least 90-95% of the portfolio in equities (and the rest in cash), there have been instances when your fund manager has held more cash. Inevitably, your fund manager has the power and control to change your scheme’s asset allocation. This is also mainly why Krishnamurthy Vijayan, chief executive officer, IDBI Asset Management Co. Ltd that manages only index funds, said that he recruited ex-dealers and not ex-fund managers to take care of index funds at his MF.
However, an ETF fund manager does not have these powers. Since the ETF units can be created or dissolved only against a basket of shares, the cash component remains the same throughout. Also, the onus to create units—as against the basket of securities—is on the market-maker, so the ETF does not really buy or sell securities in the market. Hence they don’t pay brokerage to stock brokers.
…and closed-end funds
ETFs also do not suffer from the pangs of closed-end funds where the listed market price is generally lower than the scheme’s net asset value (NAV). An ETF’s market price and NAV almost moves in tandem. If one goes up, it provides an arbitrage opportunity to the market maker to move money (either on the Nifty BeES units or the basket) and this arbitrage forces the prices to converge. For instance, on 24 March, the Nifty closed at 5522.4. Nifty BeES’ NAV was Rs 557.83 and its closing market price was Rs 559.69. Such a difference, if happens during market trading hours) provide an opportunity to market makers to make some money.
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In this particular case, the market maker will sell Nifty BeES in the market since it is quoting at a higher price in the market (Rs 559.69) and replenish his stock by buying the ETF units from Benchmark AMC at the actual NAV (Rs 557.83) . The market maker’s selling in the market will create a downward pressure on the market price of the ETF units and he will continue to indulge in this arbitrage till the time the market price of the ETF units doesn’t converge to the actual NAV. Some difference will remain, however, on account of transaction costs.
Are ETFs liquid enough?
Since only large investors, such as market markers whom the fund house appoints, can “create” and “redeem” units with the fund house, your only chance to buy and sell ETFs is on the stock exchange. Hence, liquidity is important. Some ETFs, like those typically from Benchmark AMC, enjoy good liquidity. For instance, the average trading volume of Benchmark Nifty BeES was 113,000 units a day so far in 2011, 89,463 units in 2010, 145,000 units in 2009 and 72,018 units in 2008.
However, not all ETFs enjoy good liquidity. Sensex Prudential ICICI Exchange-Traded Fund (SPICE), for example, has consistently suffered from poor liquidity. Only 81, 151 and 207 units were traded on average in 2008, 2009 and 2010, respectively. On 119 of 252 trading days in 2010, not a single SPICE unit was traded. On 46 days, less than 20 units were traded. “Since actively managed funds have outperformed ETFs, we have not been able to give much attention to SPICE. In India, fund managers have managed to outperform benchmark indices, as against the developed markets. Even ICICI Prudential AMC’s actively managed funds have done much better than our own passive funds”, says S. Naren, chief investment officer -equity, ICICI Prudential Asset Management Co. Ltd.
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Most ETFs offer an additional window for redemption if their units are not traded consistently on the stock market. For instance, SPICE’s offer document says that if units are not traded on the stock exchange (Bombay Stock Exchange) for five days, investors can redeem their units with the fund house directly. Naren claims that a majority of SPICE’s investors have chosen to not to use this window for redemption. Liquidity for gold ETFs has been much better. Throughout 2010, at least 90 units of gold ETF across fund houses were traded on a single day.
Fighting for shelf space
Though India’s first ETF house got sold out, market experts believe that this is not necessarily a bad sign for passively managed funds in India. As per the ETF landscape report released by BlackRock Inc., an US-based asset management company—and the owners of iShares ETFs (world’s largest ETF provider in terms of number of products and assets under management with a 44.1% market share)—ETFs have grown by 33.2%, compounded annually, globally in the past 10 years and 26.1% in the past five years.
In the US, MFs witnessed a net redemption (more money went out than came in) of $278.3 billion, against a net sales (more money came in than went out) of $85.9 billion during the first 10 months on 2010. With the US ETF industry having crossed the $1 trillion mark on 16 December 2010 (it took the industry 18 years to reach this milestone), the US MF industry (excluding ETFs), took 16 years to reach the $1 trillion mark.
Sadly, ETFs haven’t really taken off in India so far. According to the Association of Mutual Funds of India (Amfi) data, ETFs comprise of only 0.3% of the total industry assets. In comparison, ETFs comprise about 9% of the MF industry in the US. Why haven’t ETFs taken off then? Says Sanjiv Shah, executive director, Benchmark AMC: “Agents have traditionally sold products that fetched higher commission. ETFs are low-cost products and hence don’t pay much commission. Hence the market did not take off as much as we had anticipated.” Adds Ambareesh Baliga, chief operating officer, Way2Wealth, a broking firm: “ETFs are not a paying proposition.”
But that is not the only reason why ETFs did not pick up. Contrary to developed markets such as the US where fund managers have repeatedly found it tough to beat indices, in India actively managed funds have outperformed passive funds, consistently. “There is immense talent in the Indian MF industry. We have more than 6,000 listed companies on our stock markets; it’s not very tough for a capable fund manager to pick about 100-150 stocks of these that can outshine the market”, says Jaydeep Kashikar, director, Brainpoint Investment Centre Ltd, a Mumbai-based financial planning firm.
Ajit Dayal, director, Quantum Asset Management Co. Ltd, says that ETFs in India are “bad products” because Indian stock market indices see frequent churn of indices going in and out. “Such churn forces the fund manager to sell the scrip that moves out of the index and buy the scrips that enters the index”, he adds. Here, the ETF fund manager himself rebalances the portfolio; the scheme bears the cost. In the past three years while Sensex has changed three, two and three scrips, respectively, BSE 100 has changed 12, two, 11 scrips and the Nifty has changed three, five and four scrips, respectively. “The BSE 30 or NSE Nifty are quite suspect as indices. Some of the people who look after indices are fund managers. They change stocks in the index to the extent of 20% every year. Where is the stability of the index?”
Not all agree with Dayal though. Reid Steadman, global head of ETF licensing, Standard and Poor (S&P) Index Services, says that though NSE indices are maintained independently, “they are in line with global best practices”. India Index Services and Products Ltd (IISL)—that maintains and manages indices for NSE—has a licensing agreement with S&P for co-branding certain indices such as S&P CNX Nifty.
Benchmark’s acquisition hasn’t deterred others from launching ETFs and index funds. India Infoline Asset Management Co. Ltd, that got its MF licence recently, aims to launch passive funds initially and manage them for about a year. Motilal Oswal Asset Management Co. Ltd that started its operations last year also aims to stick to ETFs, as will IDBI Asset Management Co. Ltd that will mainly focus on index funds.
Naren of ICICI Prudential AMC says that they have no plans to wind up the scheme for now. Instead, he adds, the fund house may get aggressive and apart from educating stock brokers to recommend ETFs to investors who need them, will also look at launching specialized ETFs such as country-specific ETFs.
“While the MF industry works on a distribution model, ETFs are sold by stock brokers, not distributors who find more potential in their earnings in selling equity stocks to customers and getting them to churn. It will take time to educate brokers on ETF’s benefits”, says Naren.
What should you do
Though Mint Money believes that ETFs are good products and make a good way to construct the core of the portfolio, you don’t need to invest your entire corpus in ETFs especially if you do not have a demat account.
“Small retail investors who are wary of accessing stock markets will find it more comfortable in filling up a form, the traditional way, and investing in index funds”, says Vijayan. But since ETFs enjoy low tracking error (they track their benchmark indices more closely, on average, than index funds) and are low-cost products, at least one ETF in your portfolio bodes well.
Graphics by Ahmed Raza Khan/Mint