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  4. How to evaluate an ETF NFO

How to evaluate an ETF NFO

It’s raining ETF NFOs, and how! In the five years between 2015-19 you had about 50 new ETFs (excluding gold). In less than half that 5-year period – i.e., between 2020 and now – you have close to 50 ETFs launched! Just as many of you ask us about NFOs in the active fund space, this spate of NFOs in ETFs has evinced a lot of interest too. 

Whether it is Auto or Consumption ETFs or the Nifty Alpha 50 ETF or an international ETF like the Hang Seng Tech, there seems to suddenly be a plethora of options for you to choose from. These options have come a long way from the only available ETFs a decade and a half ago – Nifty, Junior Nifty (now called Next 50), or Nifty Bank. 

So, are there better and promising options coming your way now and should you be attracted by every such ETF that is seemingly unique?

ETF NFOs

To put it very plainly – we think there is no need to rush into ETF NFOs. Not all of them will fit your portfolio, just as it is with active funds. Even if you are interested in any unique ETF and believe it holds potential, waiting for a while to know the ETF’s tracking error, turnover data and whether it trades close to its NAV (read our article on this here), will help you make more optimal choices. 

In this article, we’ll explain how to approach ETF NFOs and how to navigate different categories of ETFs. 

(Please note that what we state here, barring our reference to ETF turnover, will apply equally to index funds and other passive fund-of-funds as well)

Background

First, let’s lay down some context to why there are more ETFs now than earlier. There can be many reasons including Indian markets getting more mature and following the Western trend of providing more passive options and so on. But at PrimeInvestor, we think the changing trend can largely be attributed to three specific reasons in the Indian context: 

  • One, from 2018 when SEBI’s new categories started, AMCs were allowed to have only one fund under each SEBI-defined category. However, categories such as sector/thematic funds, index funds, ETFs, international funds and solution-oriented funds were allowed to have multiple funds provided they did not have the same investing style/strategy. In our opinion, these categories became an option for fund houses to garner fresh inflows where they had a full stack across other categories already. 
  • Two, post 2010 (post crisis period), active funds have either been struggling to beat their benchmarks or have seen their margin of outperformance over benchmark shrink steadily. This problem worsened when SEBI mandated that the TRI (total return index, which includes dividends of the stocks in the index) of any index should be the primary benchmark for a fund. This further saw funds, especially in categories such as the large cap, suddenly struggling to outperform, leading to outflows as well. Passive funds – both index funds and ETFs emerged as an option for AMCs to meet the deficiency. 
  • Three, new-age AMCs with fintech backgrounds are trying to create a niche by making the foray into the fund management space directly through passive funds. Existing established and traditional AMCs, to ensure they do not lose their market, are also aggressively coming up with innovative ETFs and index products. The Bharat bond in the debt ETF space or HDFC’s fund-of-fund model with ETFs/index funds from Credit Suisse and Kotak’s with Nasdaq iShares ETFs are examples. So, you can expect more innovative ETFs – thematic, multi factor investing, debt ETFs and so on. 

It is important that you are aware of the business aspect of a product to a manufacturer that you are buying. Hence this context 😊

All portfolio rules apply to ETFs too!

Just like active funds, not every ETF that comes into the market needs to be in your portfolio! Your own asset allocation, your time frame and risk profile, style and strategy mix that your portfolio already has, whether it can take on more risk, and many such factors will have to be considered while choosing an ETF as well. 

For example, if your portfolio already has adequate exposure to well-performing value funds, then adding a value ETF will only tilt your portfolio further towards one style of investing. When value underperforms, both your active and passive value fund may underperform, even if one underperforms less than the other. So, you are not necessarily diversifying effectively. 

Similarly, when you have a portfolio that has a goal within say 3-5 years, then adding a target maturity debt fund with a 10–15-year maturity will only enhance the volatility in your portfolio and even result in poor returns. So – always apply the regular rules of portfolio building to see how an ETF fits your existing portfolio before trying to invest in it.

Which ETFs will suit your portfolio – things to know

We think you should not enter any ETF without knowing whether it is well-traded and whether its tracking error is low. But there are other factors that you also need to know before choosing an ETF, even if you did wait for the track record to build up. 

To know these, let’s first classify the current spate of new ETFs under the following broadheads.

  • Traditional/market cap index-based ETFs 
  • Single factor or multi-factor index ETFs
  • Sector/thematic ETFs
  • International or international-themed ETFs
  • Target maturity debt ETFs

Let us look at how you should approach each of these categories of ETFs.

#1 Traditional/market-cap based ETFs

These ETFs are built on indices that are purely market cap based. Or in other words, they are chosen and receive their index weights based on their market cap. Popular market-cap based indices include Nifty 50, Nifty 100, Next 500, Nifty Next 50, Nifty Midcap 150 and Nifty Smallcap 250. You do have indices from BSE such as the Sensex as well (S&P indices) but these are limited. 

Sector-based ETFs can also be market-cap based – for example, the Bank Nifty consists of the largest and most liquid banking stocks. But we will take up sector ETFs separately. 

The biggest advantage with broad market-cap based ETFs is that you are truly with the market. When the market is favoring a stock, its price goes up. So does its market cap. As a result, the stock receives higher weight in the index. In other words, your stake in winners automatically goes up. And the reverse is also true. Therefore, you always stay with the market mood. Whether an active fund will do better is a separate point. But with such market-cap broad ETFs, you know that you will simply ride with the market and go where it goes. 

These are the kind of ETFs that should find a place in the core of your portfolio – alongside your active funds or even if you decide to have a passive-only portfolio. Some of these indices can even replace large-cap funds (like the Nifty 50). Others like the Midcap 150 or Next 50 can be a part of your aggressive allocation alongside active mid or small-cap funds. 

As there are quite a few existing ETFs in this space, you can wait to see if the new ones fare better on tracking error or turnover before choosing them. Don’t place excessive attention on expense ratios, especially as the newer AMCs build their marketing around it. Expense ratios are always subject to change, and most ETFs aren’t high-expenses to begin with. Tracking error is just as important; ETFs with lower expense ratios have had higher tracking error than those with higher expense ratios.

#2 Single and multi-factor indices

When an ETF is built on a single factor (or rule/metric) like value, quality, or low volatility it is called (single) factor investing. When the model is built using multiple factors – like low volatility plus with alpha, for example – it is called multi-factor investing. 

Such an index is not built based on market cap movement. Rather, a set of rules (based on the factors chosen) are built and stocks satisfying those rules find a place in the index, with appropriate filters. So, there is an element of ‘choice’. The weights to a stock in such indices is decided by its score on the factors, and not on its market-cap. Once you understand this, you also understand that it is not the same as investing in a market cap-based index where you go with the market.  

The data below, for example, will give you the movement of the Nifty Alpha Low Vol 30 index versus the Nifty 50 on a rolling 3-year return basis. You will see the former outperforming the Nifty 50 for a good time, and then see the outperformance narrowing. The Nifty 50 is now beating the Alpha Low Vol 30 index. In other words, you cannot expect factor indices to ‘go with the market’. Depending on how well the factors are in play, they may beat or trail the index.

Now, the key thing to note in such factor indices (and this is something that we are learning too!) is that these indices are either more recently built or are customised based on the requirement of the ETF manufacturer (AMC) and are back-tested. So, an NV20 index or Low Vol or Alpha Low Vol index would have far more back tested data than data since its launch date. What of it, you may ask. 

As builders of portfolios ourselves, we can tell you the perils of relying on back-tested models. A model can be tweaked to provide the most optimal back-tested outcome! It is not possible to do this with a live portfolio, right? (As an aside, this is why relying on back tested data for a NEW portfolio is never a great idea). 

For example, the Nifty Alpha Low Vol 30 index was launched in 2017 but with a base date of 2005. So, you will find back tested index data since then. So, since this back-worked index’s base date, the Nifty Alpha Low Vol 30 beat the Nifty 50 about 83% of the time considering 3-year rolling return (as of January 14, 2022). Good enough. But break this down into more recent periods.

Between the index’s real launch in 2017 and the Alpha Low Vol ETF’s launch in August 2020, the 3-year rolling outperformance was 100% over a 6-year period. Go even more recently – the 3-year rolling return now has the Nifty Alpha Low Vol beating the Nifty 50 just 58% of the time. The second table below will also tell you that the difference in the average returns compared with Nifty 50 has also shrunk considerably – in other words, the margin of outperformance has thinned.

What are we trying to tell you here?
  • One, back-tested data may not tell you the reality. Many of the factor indices have data that is back-calculated and performance in real-time markets can tell a different story.
  • Two, a factor index need not be invincible. Like many fund strategies, these factors too have their periods of underperformance - and that means they may not even be able to beat the Nifty 50 for prolonged periods. 
  • Three, if this is the case, it may be too early to conclude that factor indices can replace your traditional market cap-based indices. You may at best use them to play a specific style or strategy than replace the core indices.
  • Four, when you do so, you should also know whether your own active funds are good enough for such strategies or you need these indices. 

Simply put, a factor index cannot count as the core of your portfolio as yet. So, don’t try to go overboard with those until such time they have sufficient track record to showcase their consistency or otherwise.

#3 Sector/thematic ETFs

Sector ETFs carry the same risks as active sector funds as far as their addition in your portfolio is concerned. One, they are subject to the risk of timing the sector. Two, whether your portfolio can take on more risk from sector exposure also needs to be assessed.  Hence, there is no sanctity in adding these at the time of NFO just because they are launched. 

The other thing you need to be cognisant of is both the tracking error and turnover in sector ETFs. Barring the top 1 or 2 indices - Bank ETFs, one of the oldest in the sector category - have historically seen very poor turnover. Similarly, the recent launches of healthcare ETFs have seen higher tracking error compared with the index. To know more about the perils of high tracking error and low volume read our article on this. Hence, it becomes necessary for you to wait for an ETF to develop some track record so that you can assess how they are doing on this count. 

Next, the question of whether you need an active or passive fund to play a sector can elicit a very mixed response depending on the nature of stocks and weights that the index has. For example, many active banking and financial services sector funds managed to beat the Nifty Bank over a 5-year period. However, none of them delivered more than the Nifty Financial Services index over a 5-year period. So, choosing a bank ETF over active funds may not be the best of ideas if you want to ‘beat’ the sector, while it may make sense if you choose a Financial Services ETF. 

Hence, in a sector fund, assessing how existing active funds perform against index is important. After all, the idea of taking sector or thematic exposure is to beat the market or ride a trend to its fullest potential! And remember, sector funds account for the ‘satellite’ part of your portfolio. You add them to generate alpha. 

Finally, you may also need to assess whether you want to play a limited opportunity in a sector directly through stocks. For example, you may want to focus on a specific segment of auto like electric vehicles or a specific segment of financials – like small finance banks or home loans or fintech platforms. In such cases, going for the whole sector may stifle returns than going directly with stocks.

#4 International funds or international themed funds

This is one segment where you can actively look for passive options as many international markets, especially the US, have indices that beat a majority of the active funds. In this article, we explain in detail why we prefer the passive route here and how you can choose which market to invest in.  

With international passive funds, it is hard to get data for you to compare whether an ETF has low tracking error since the returns in your ETF will be in rupee terms, but the underlying index will not. However, you should at least wait for turnover data to know if the ETF is well traded. If not, fund-of-fund options or funds that invest in international ETFs directly are all good routes to tapping foreign markets. So, even if you find the theme interesting, wait for data on turnover when it comes to ETFs. Some ETFs also reduce the deviation between their market price and NAV with time (through market making). 

Since international investing is best viewed as a diversifier for a long-term portfolio, you don’t need to be too fixated on timing it. SIP investing would also help.

#5 Target maturity debt ETFs

Barring liquid ETFs and a few gilt ETFs, there were no debt ETFs in the Indian space. This changed with the launch of Bharat Bond ETFs in end 2019. This marked the launch of target maturity funds. You can read more about target maturity funds here and about Bharat bonds here.  While Bharat Bond ETF series are from Edelweiss, you now have other fund houses providing this with a combination of SDLs (state development loans) as well. 

These ETFs are nothing but open-ended, liquid FMPs with high quality instruments. So, it becomes important for you to either align your own goal with the maturity of these ETFs or know how to time your entry and exit (duration play based on interest rate). These offer a good option for those looking at low-cost debt investing with no risk of credit prevalent in some active debt funds. Here again, waiting to know whether the turnover of the ETF is good will help you prevent any risk of illiquidity.

To summarise

  1. Avoid rushing into ETF NFOs and wait for data on turnover and tracking error. 
  2. Ensure that the ETF, like any other fund, fits your portfolio.
  3. New-age ETFs such as factor ETFs (also called smart beta ETFs) need to establish record across market phases. Don’t go overboard on them.
  4. Assess whether you need a sector ETF or can do with sector funds or even individual stocks.
  5. Passive route is a good way to take international exposure provided you keep in mind point 1. 
  6. Target maturity debt ETFs need understanding of the interest rate cycle and also require you to align your goals with that of the ETF’s maturity if you are truly passive.

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