The concept of an Exchange Traded Fund (ETF) is that you buy a mutual fund like a stock on an exchange. This is suitable for investors who want to invest in a basket of instruments or an otherwise difficult-to-invest market.
For example, investors in India may want to invest directly in US stocks. But the legal procedures for direct investment are painful — instead, they could buy an ETF that, in turn, is based on a US stock index.
When you buy a unit of, say, NiftyBeES (an ETF by Benchmark Mutual Fund), you get a share worth 1/10th of the Nifty price; so for Rs. 580 you could buy a piece of an index that, without the ETF, could take you more than 40 lakhs to fully construct.
While most index funds lock you in for a year or so (with a 1% exit load) ETFs can be sold any time without such a penalty. But it could just be that you can't sell very easily if the ETF is not well traded — getting a price lower than the fund's NAV is, in a way, an exit load.
There are now more than 2000 ETFs in the US, managing over $1 trillion. To put that in perspective, that is more than the number of stocks traded daily on the NSE in India, and about 2/3rd of India's total market capitalization.
In India the ETF scene is different from the west. ETFs are more expensive than buying a regular mutual fund, since mutual funds have no entry loads anymore. For an ETF, the brokerage you pay — the average of 0.2% to 0.5% per transaction — means you pay more just to get in.
ETFs in India can only invest passively — that is, with a set of well-defined rules that contains no discretion; indexes and commodities are candidates. So a NiftyBeES, an ETF by Benchmark Mutual Fund which specializes in ETFs, invests in stocks that make up the Nifty Index, in the same proportion as the Nifty dictates. GoldBeES buys Gold, and JuniorBeES buys into stocks of the Nifty Junior Index. Other ETFs from Reliance, UTI, Motilal Oswal and a number of other funds now allow you similar investments — and apart from Gold and the standard Indian indexes, you can buy into an ETF that invests in the Nasdaq 100 (for you Apple lovers) or even the Hang Seng index. This makes ETF investing require very little in terms of management fees — since index based buying is, for the most part, automated. (Gold ETFs charge higher fees for the storage costs of physical gold)
But index investing, say critics, has not worked in India. Simply put, regular mutual funds have done much better — and in the past 5 years, the data seems to bear that out; most of the diversified funds that were topping the charts five years ago are still topping charts today, and have beaten the 10% annualized return of the Sensex/Nifty comfortably, even after considering fees. If mutual funds beat the stuffing out of indexes, then why go for an index?
The counters to this argument are that as India matures, we will move to the more standard returns seen by countries in the west, and then ETFs and Index investing will be considerably better. I argue that the problem is in the indexes , which are horribly skewed towards a few stocks:
Number of stocks in the NSE Nifty: 50 (Fifty)
Number of stocks in the BSE Sensex: 30 (Thirty)
Number of stocks that add up to 25% weight in the Nifty: 3
(Reliance, Infosys, ICICI)
(They add up to 30% in the Sensex)
Number of stocks that add up to 50% weight in the Nifty: 8
(In the Sensex: 7)
The weight of Financial Stocks in the Nifty and Sensex: 25-27%
The weight of Financial, Energy and Infotech stocks in the Nifty/Sensex: 60%
In effect, the barometers of our economy, the indexes that we look at, are skewed towards a few stocks and sectors. Healthcare gets just 1% of the Sensex and 3.5% of the Nifty; our consumer durables, automobiles and telecom sectors add up to just 20% of either index.
Would you like to invest in certain sectors through ETFs and sectoral indexes? Things get worse:
Weight of ICICI and HDFC Bank in the Banking Index: 52%
(out of 12 stocks)
Weight of Infosys in the CNX IT Index: 56%
(out of 20 stocks)
(And TCS is another 21%)
Weight of DLF and Unitech in the CNX Realty index: 53%
(Out of 10 stocks)
You invest in an index to get some level of diversification, which is totally lost with such concentration of weights. In the US this has been solved to some extent by using "equal weighted" indexes and ETFs on them — where each stock is given the same weight. We have no equal weighted ETFs or indexes in India.
Having only 10-15 stocks in each sector index is also very shallow; I would attribute that to a lack of depth in our markets, that we don't have enough stocks to represent each sector. The depth issue is even more if you tried to create an ETF on the broadest index (the S&P 500), where the smallest stock has a market capitalization of just 76 crores. That is lesser than the smallest scam that you can be outraged about.
There are ETFs in the US that invest in commodities (not just Gold) through futures contracts. These has been an issue of regulator turf wars in India and such ETFs don't exist here — but it would have been nice to be able to ride the growth of silver through ETFs, or crude oil, for that matter. ETFs that use leverage or purely options are frowned upon. Benchmark even proposed a Covered Call ETF a long time back but that was not approved by SEBI — and later, mutual funds were banned from writing options. (Covered calls are where you own stock and write a call option, which can provide income when stocks are range-bound.)
On the bright side, ETFs are beginning to see some action. Earlier Benchmark was the only company interested in ETFs (the Prudential SPICE Sensex ETF was moribund); now, nearly every fund house has an ETF, with the most popular being Gold ETFs. So much so that Reliance created a new mutual fund (not an ETF) whose only job was to invest in their own Gold ETF! (Ostensibly to allow non-demat holders to invest in Gold.) Motilal Oswal is getting into the space and offering ETFs on the Nasdaq 100, another on the CNX 100 (which is broader than a 50-stock basket) and one on the Nifty 50, but weighted by fundamentals rather than market cap. Benchmark Mutual Fund has recently been bought over by Goldman Sachs for 130 crore and the ETF bazaar may be about to see dramatic changes. ETFs in India are less than 1% of total Mutual Fund assets; there is enough room to grow.
The scope for ETFs will increase as markets mature, and the maturity needs to reflect in the depth of our indexes as well. We should create more indexes, including combinations of fundamental and technical criteria that allow investors to get access to different kinds of stocks in a single ETF investment. Finally, our regulators need to work together and allow investors to buy ETFs based on commodity baskets, bond markets or global themes like water.