Making smalltalk

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Are Exchange Traded Funds a new & temporary trend – or do they have a future in India? What’s the scope of ETF investments? In the 5th and final post of the ETF Education Series, we analyse these key questions. In case you are new to ETFs, you should start with the first article, which covers ETF basics.

History of ETFs in India

India got its first ETF in 2001 when Benchmark Mutual Fund launched the Nifty ETF Fund. The defined objective was to track the performance of the Nifty-50 index. Since then, the ETF industry in India has witnessed a slow but steady growth.

Benchmark continued to be ETF pioneers in India, launching the first Fixed Income ETF (Liquid BeEs) in 2004 and the first Gold ETF (Gold BeEs) in 2007.

Benchmark sold its business to Goldman Sachs in 2011, who in turn sold it to Reliance Mutual Fund in 2015. By the way – these funds, and even the broader team managing them, are still in operation and in fact, are amongst the most active & liquid funds in their categories today. Needless to say, many AMCs have followed suit since then.

There was a period especially in the early 2010s when ETFs became associated with a way to invest in gold. In fact, more than 50% of total ETF assets were in gold funds for most years in between 2009-2014.

2015 to present: 10x Growth of ETFs

Since 2015, the ETF landscape has not only become much bigger but also more diverse. Assets under Management for ETFs has grown from approx. 13,800 crores in December 2014 to more than 1,41,500 crores as of May 2019 – that’s a 10x (or 1,000%) in less than 5 years, at a CAGR of more than 55%! Interestingly, the bulk of this growth has come from the equity segment.

Two decisions/events played a crucial role in enabling this tremendous growth in ETFs:

1. CPSE: In March 2014, the ETF industry received a huge boost when the Indian Government decided to raise money by divesting their share in public-sector undertakings (PSUs) via ETFs. The Central Public Sector Enterprises (CPSE) ETF, comprised of 10 quality PSUs back then, launched in March 2014
2. EPFO: In August 2015, the Employees’ Provident Fund Organisation (EPFO) announced that it would take equity exposure  only via ETFs. Note that EPFO is the authority charged with investing/managing the PF and PPF accounts of all Indians. Thanks to this, a sizeable chunk of money has steadily come into ETFs in the recent years, and this is only set to increase each year as more people contribute to their PF/PPF accounts.

“The Government had mandated Retirement and superannuation funds to invest at least 5% of yearly accretion in Equity markets. Many of them have opted ETFs for such investments”

says Sharwan Goyal, who is the fund manager of 4 ETFs at UTI Mutual Fund, one of the largest AMCs in India. “In addition to this, Government decided to disinvest part of their holding through ETFs. This has helped the overall growth of ETFs in India”, he adds.

Other factors boosting the ETF landscape in India:

• Underperformance of active mutual funds: With the majority of the active equity mutual funds underperforming the benchmark index in 2018, there has been a renewed interest in the active vs. passive debate, with many investors moving to low-cost passive alternatives.

SPIVA, which is maintained by S&P Dow-Jones & tracks the performance of active funds vs. its benchmarks, reported that more than 90% active large-cap funds underperformed their respective benchmarks

• Growing investor awareness & education: Thanks to the continuous efforts of SEBI, AMCs, brokerages (many of whom are now recommending ETFs to new investors rather than single stocks), and the numerous evangelists & advocates of low-cost investing, there is a lot more awareness about ETFs and their advantages. We recently polled the Twitter junta on ETFs, and the responses are quite encouraging (admittedly on a small sample size):

• Government promoting ETFs: The Govt. is increasingly using ETF as a tool to divest shareholding & raise capital.
  • Bharat-22 ETF launched in 2017
  • Another round of subscription to CPSE took place in July 2019
  • Budget 2019 proposed Tax-Deductible 80C variant of CPSE & Bharat-22 ETFs – this will further boost investments in Exchange Traded Funds
  • Reports suggest that a Public-Sector Banks (PSBs) focused ETF is also on the cards

Key bottlenecks for ETF Adoption in India:

Despite its numerous advantages & benefits, ETF penetration amongst investors is still low relative to mutual funds. One of the key reasons for this is that distributors have no incentive to “recommend” these products to clients. Distributors are the people/firms who “recommend” & sell investment products to clients.

Since ETFs usually don’t pay any commissions (in order to keep down costs), whereas mutual funds do, distributors are generally more incentivised to push MFs even if ETFs might be better to clients.

Other reasons that have prevented include the historically low liquidity & trading volume, though this has improved in recent years. SIPs in ETFs are also not as convenient as Mutual Funds, stopping many investors from using ETFs. Finally, the low variety of Equity ETFs – with none focused on Smallcap & only a couple in the Midcap space – has also kept many investors away.

However, many professionals don’t feel the need to have more diverse or niche ETF strategies just yet. “Currently there are 79 ETFs available in India, out of which 59 ETFs are linked to 22 different Equity Indices. Looking at current penetration of ETFs and general market depth, this is quite a sufficient spread. Flagship ETFs on broad market indices should reach to next level before availability of new ETFs”, adds Sharwan of UTI.

The Road Ahead

ETFs have taken over the world, with AuM in such funds surpassing those in traditional mutual funds in many countries. The low-cost & instant liquidity provided by ETFs have appealed to investors globally.

But the road wasn’t always smooth – the challenges that ETFs are experiencing in the Indian market now is actually very similar to the ones ETFs faced in the developed markets like US & UK in its initial years.

ETFs became mainstream on the backdrop of the Global Financial Crisis of 2008, as global investors remembered that returns can’t be controlled, but costs can be. (Learn more how 3 stock market crashes changed the investing world). In the following 10 years, ETF assets grew from $700bn in 2008 to more than $5tn as of 2019.

In India, the ETF market is now at an interesting threshold as ETFs are back into focus due to the underperformance of active funds. This renewed focus on costs might just be the catalyst for investors to seek lower-cost & better alternatives & experience the benefits of Exchange Traded Funds.

As an investor, I’d love for the ETF market to grow. If the trends in developed economies are anything to go by, the increased adoption of ETFs leads to the betterment of the overall market by reducing costs.

For example, the bigger/popular large-cap ETFs in the US now charge an expense ratio of 0.03% or even less – in fact, some AMCs have even launched no-fee Exchange Traded Funds that don’t charge investors! As a result, mutual funds in the US have also drastically reduced their fees. Imagine – wouldn’t it be nice to invest ₹1,00,000 in the Nifty-50 and pay only ₹30 for that, rather than ₹1,000-2,000 in mutual fund fees?

If you are a long-term investor with SIPs every month & no intention of redeeming in the near future, then ETFs can be an ideal option. Happy investing!

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This post is the 4th & final one in the ETF Education Series. If you are new to ETFs or interested to learn more about them, we recommend reading the entire series:

1. ETF 101 – What is an ETF?
2. ETF Liquidity, Creation, and The Role of Authorised Participants
3. 3 Stock Market Crashes that changed Investing: Origins of MFs & ETF
4. ETFs – Growth & Scope in India