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With some classes of domestic mutual funds struggling to deliver on their promise and a global shift towards ETFs and index investing, the local interest in ETFs is healthy and welcome. But to think that Indian ETFs are fault-free and the ideal route to investing is flawed.

Here’s why, and how to negotiate the ETF space in India.

The construction

ETFs are only as good as the indices they represent. Typically, most Indian indices use a stock’s market capitalisation to decide its weight in the index – which means stocks with the biggest market cap get the highest weight. Globally this is among the most time-tested index construction method as it gives you more exposure to stocks that are doing well and cuts down your exposure to underperforming ones.

Wondering if you should invest in ETFs?

But this is not necessarily good at all times as the higher weighted stock may not be the best in terms of fundamentals, valuation, or potential. We have seen this in the rally up to 2008 when several infrastructure and real estate stocks were part of the top 50 or 100 but experienced a hard fall from grace as their rise was not supported by fundamentals. Similarly, a market-cap based index may reduce exposure to stocks that are beaten down by overt pessimism than due to fundamentals. In such cases, it would be cutting your exposure on stocks that might actually be offering value.

Other than market-cap based indices, Indian bourses now have strategy-based indices. But is the index itself good? Take the Nifty 50 Value 20, on which ETFs are available. This index takes the Nifty 50 stocks, assigns weights to return on capital employed, price-to-earnings, price-to-book, and dividend yield. The problem? ROCE gets a 40% weight, while price-to-book gets just 20%. The result is that the “value” index contains stocks such as Hindustan Unilever and TCS which certainly do not fit the value tag.

The Nifty 500 Value 50 is more balanced by using dividend yields, price to book, price to earnings, and price to sales. However, it takes just 1 year’s performance into account – which is misleading, as it may not spot trends in sales or profit growth and it may leave other stocks out. The metrics too, aren’t exhaustive. The index, for example, continues to house Vakrangee, Reliance Capital, and Reliance Infrastructure.

Bottom line: Marketcap-based indices are among the more established, simple and relatively safer option to play the market for want of better options in India currently. But be prepared to be hurt when markets move away from fundamentals. Also, quite a few strategy-based indices suffer from limitations in construction.

The performance

In other cases, while the index may appear satisfactory, its performance could be another matter. Take the Nifty 100 Quality 30. Given the performance of the quality strategy, this index should have delivered well. But the index has managed to beat the Nifty 100 just 35% of the time when rolling 3-year returns for the past 5 years. On a 1-year rolling return basis, the index has lagged the Nifty 100 over half the time.

Or consider the Sensex Next 50, on which ETFs are available. This index is complicated blend of the Sensex 50 and the BSE LargeMidcap, which is in turn derived from the BSE Largecap and the BSE Midcap indices. Ideally, this should be able to beat the bellwether Sensex over the longer term, being a blend of mid-cap and large-cap stocks. Not quite. The index beat the BSE 100 and the Sensex 70% of the time on a 3-year rolling return basis over the past 5 years. The Nifty Next 50, on the other hand beat the Nifty 100 index a good 85% of the time, without the benefit of mid-cap stocks.

Bottomline: While the index may seemingly promise superior strategy and performance, the reality may be different.

The variety

The number of ETFs may seem many, numbering over 80. The variety, though, is limited. The Nifty 50 and the Sensex account for a third of these. Gold and bank ETFs are another fifth. For other pockets, such as mid-caps, themes, strategies, and even asset classes, options are limited. The US ETF market, on the other hand, holds over 1400 ETFs across equity, commodities, bonds and has enormous array of strategies, sectors, and styles. The Indian ETF market, while expanding, is not the US or any developed ETF market.

Obviously, as the ETF market in India is new, the lack of variety is not surprising. Variety will come in gradually as markets develop. For example, the newly-announced Bharat Bond ETF is very different from the existing debt ETFs – liquid and gilt – as well as debt funds themselves.

In the meantime, though, it leaves shortcomings where a long-term portfolio is concerned. Portfolios need to blend investment strategies, market capitalisations, and asset classes. Relying on the Nifty 50, the Sensex, or the Nifty 100 can result in sub-optimal returns – it will mean missing opportunities outside these indices and in other themes and strategies.

For example, take a portfolio of the Nifty Midcap 100, the Nifty 100, the Nifty Next 50, and the Nifty 500 in a 20:30:30:20 blend. An SIP since January 2014 would have yielded an IRR of about 9.1% today. Now take a portfolio, with funds across investment styles and asset-allocated with 25% in debt and 30% in large-cap. The funds considered were ICICI Pru Bluechip (large-cap value), Invesco India Growth Opportunities (multi-cap growth), Parag Parikh Long Term Value (value plus international), L&T Midcap and HDFC Corporate Bond. This portfolio would have yielded an IRR of 10.3%.And this, with a 30% in debt, as opposed to the all equity index portfolio we mentioned in the example. Of course, you do need to choose your funds with care.

Bottomline: until ETFs get more varied in terms of strategies, themes, and market caps in both debt and equity, it is necessary to move beyond ETFs.

The volumes

Finally, where there is an ETF, there needs to be sufficient trading volumes. Good volumes ensure two things – one, that you’re able to buy and sell units when you need to and that you’re choice is not restricted. Two, that the chances of the ETF return diverging from the underlying index’s return (tracking error) is minimised as mismatches between demand for and supply of units can cause an ETF’s market price to move differently from the underlying index.

There are ETFs that make good investments, which you can and should add to your portfolio. This could be one of two types. The first is where the index beats equivalent equity funds, such as in large-caps. The second is where ETFs can fill  gaps in mutual fund offerings.

As far as volumes go, however, Indian ETFs are a mixed bag. Some ETFs hold steady in terms of volumes while others can fluctuate. It depends on both the AMC and the ETF itself. Consider just the past six months. HDFC Nifty ETF, for example, saw traded turnover be as low as Rs 1.14 lakh to as much as Rs 87.55 lakh. Traded value in the ETF has jumped from Rs 1.39 lakh on one day to Rs 11.7 lakh the next to Rs 5.45 lakh the third. Nippon India Nifty Bees, on the other hand has been far more stable in terms of trading fluctuations. Several ETFs see virtually no trading on several days. Low volumes and traded values could either be because the ETF size itself is small or because the AMC is unable to push market makers into injecting volumes.

Bottomline: volume mismatches don’t always lead to tracking error. However, erratic volumes could make it hard for you to deploy your investment quickly, or narrow down the choices of investible ETFs, and require you to do the homework in identifying ETFs where volumes are healthy.

Investing in ETFs

So does that mean ETFs are not an investment option? No.

There are ETFs that make good investments, which you can and should add to your portfolio. This could be one of two types. The first is where the index beats equivalent equity funds, such as in large-caps. The second is where ETFs can fill  gaps in mutual fund offerings. Mixing such ETFs with other equity and debt funds will give you a more balanced and rounded-out portfolio and could be lower cost as well.

Next, ETFs score over index and equity funds in their ability to let you lock into a particular level. If, for example, markets see high intra-day volatility, an ETF would help you buy at a specific low point during the trading day. Both index funds and equity funds would only give you end-of-day NAVs.

 What you should do is to treat ETFs like any other investment. Essentially,

  • Be selective in the ETF you invest in. This involves understanding the underlying index, how the that index has come by, the volatility involved, and how it compares to other indexes and equity/ debt funds. Our subscription service will include ETF recommendations, which considers all these factors.
  • Don’t assume an ETF is good because it’s an ETF; you can and do have unsuitable ETFs. An ETF is not a worthwhile investment just because it is passive and low cost. Returns, how the index behaves, what role it plays in your portfolio, how it helps diversify your investments, and the performance of index/equity fund alternatives matter.
  • Track the performance of the ETF to ensure that the index still fits your portfolio and that there aren’t better alternatives, whether in index funds or active funds, that you can go for. While long-term investing requires a buy-and-hold strategy, it doesn’t mean you need to hold the same index/fund all the time.
  • Mix ETFs with equity and debt funds to build a portfolio that is properly asset-allocated and which combines different investment styles to effectively capture market opportunities.
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3 thoughts on “Should you invest in Indian ETFs?”

  1. Thank you , this is definitely the most detailed article I’ve read on etfs.
    Q1: is this how more experienced markets like USA build their nifty etfs?
    Q2: if you were allowed to build an etf, how would you ?

    1. Thanks Nithin,

      Experienced markets build ETFs in a variety of ways; as mentioned, market cap weights are the most popular, but there are other factors using which scores are built and weighted. You also have smart-beta ETFs in developed markets, that take a regular index and use quantitative models to further filter and build portfolios. I think smart beta ETFs offer a good blend of a passive-index-plus approach. Additionally, you have index creators who are not necessarily the exchanges in US markets, unlike Indian markets.

      Thanks,
      Bhavana

  2. Nice article. ETFs may have lower cost than index funds, but then you need to have a demat account and bear the associated costs. Personally, I would prefer index funds with all the suitable parameters, e.g. a Nifty index fund over a large cap fund.
    Regards,

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