The ETF edge: smarter route to index investing

The ETF edge: smarter route to index investing

Markets have returned 72.08% so far this year. Is your equity portfolio up that much? Investors in markets often feel that they have done well, but they usually count just their profits and neglect the losses.

If you invest directly through stocks, chances are that your return is around this number or lower as some stocks may have outperformed but others may have underperformed the index. If you invest through mutual funds, your experience at the portfolio level would be similar. For example, large-cap funds, on an average, have risen by 70% over the same time. So, had you bought the index instead of a large-cap fund, you would have gained more and paid less in costs.

We need to re-examine this entity called “index". It is not just a way to track the health of the markets and benchmark returns from products that invest in the same market, but also to actually invest and get that average market return.

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There is enough research out there that proves that there is no fund manager in the world who has managed to beat the index consistently over time. The same research points to index investing—or buying all the shares in an index and holding them till the index itself changes its composition—as a way of investing in equities that involves the lowest cost, least effort and lowest risk.

Number crunching on the Indian markets show an average return of 12-15% a year, if the index is held over a 10-year period. You could buy either the Nifty or the Sensex. Index investing is cheaper because you do not have to pay for all the research and star fund manager salaries. A one percentage point difference in cost for Rs1 lakh invested for 20 years will yield a difference in return of around 19 percentage points at an assumed return of 15%.

Index investing also frees you from the burden of choice and of tracking your investments. With over 250 equity funds in the market, getting to choose the fund you finally buy is an exercise in itself. Next, you need to track its performance to see if it is still at the top of the heap. Just buying an index does away with this burden of choice and the need to track.

Once you decide to take the index-investing road, you have a choice of two buses in the mutual funds space.

First, called index funds, will behave like any other mutual fund, but will invest only in index stocks. These do not list on the stock exchanges (though this will change once all funds begin to list). Second, called exchange-traded funds (ETFs), will also invest in index scrips, but through a slightly more roundabout process—one that makes their costs lower and their efficiency in mimicking a fund smarter.

Money Matters recommends that you hop into the ETF bus to maximize your returns from the index-investing approach. Here are two reasons why you should take this ride.

Lower expenses

ETFs, much like any other mutual fund, incur costs such as fund management, administration marketing and so on. Typically, while active funds can charge up to 2.5% of the fund’s corpus every year, index funds can charge up to 1.5%, primarily because less effort goes in managing and marketing passive funds. Many index funds charge lower fees, though some such as Tata Index Fund and Birla Sun Life Index Fund still charge the full 1.5%. On the other hand, the average expense ratio charged by ETFs is 0.68%.

Though these differences look small, they can take away large bites out of your returns over the long term. Back of the envelope calculations show that if you invest Rs50,000 each in Nifty BeES (the biggest ETF on the Nifty) and an index fund for a 20-year period and the market rises by, say, 15% per annum, you will earn Rs7.50 lakh sitting in the ETF bus as against Rs6.29 lakh through an index fund.

If two products are tracking the same index, but one gives you a higher return, it doesn’t take too much to make a choice.

Lower tracking error

Just as you look at factors such as performance before you pick actively managed funds, you must look at the tracking error of passive funds (index mimicking funds). This is the difference in the performance of the fund from its benchmark index. The lower the tracking error, the better is your ETF. Tracking error happens due to fees charged by the fund, the amount of cash holdings and so on. Investors make the error of appreciating an index fund that outperforms the index. If you want outperformance, go to a managed fund. A good index mimicking product is one that will give you almost the same return as the index, or one with the lowest tracking error.

Apart from lower fees, an ETF’s innovative structure also ensures that it’s underlying portfolio is, at all times, mapped closer to its benchmark index than that of an index fund.

An ETF does not collect money from you directly. It only deals with a few market entities, known as authorized participants (AP). Assume that your ETF is benchmarked against the Nifty index. Remember, Nifty consists of 50 stocks. These APs buy (from the stock market) and surrender a basket of these 50 scrips (in proportion similar to that of Nifty) and exchange them for one ETF unit. They would then sell these ETF units in the stock market where the investor can go and buy.

Such is an ETF’s structure that even if the fund—say, in bad markets—wants to voluntarily hold more cash and less stocks, it can’t do so. This is because fresh units can only be created in exchange of a basket of securities, including a small portion of cash that is pre-defined.

Unlike an occasional index fund that is known to sometimes actively manage its portfolio in the middle of the month to earn a kicker in returns despite going against its mandate of passive management.

A lower and restricted cash level also ensures that an ETF is almost always fully invested in line with its benchmark index and mimics the index better. Better mimicking leads to lower tracking error. The average tracking error of ETFs as on November-end is 0.76, as against 1.26 of index funds. The difference tells the story.

Graphics by Yogesh Kumar / Mint