Product Differentiation In ETF

By: Sanjay Dongre and Tavaga Research

“You buy the NIFTY stocks in the same proportion as in the Index, nothing to decide on which stock, how much of it or when to buy it; no rocket science involved.”

This is something that we are familiar with as many investors raise questions, “given that it is elementary, doesn’t matter whichever ETF I buy, I still get a long exposure to the NIFTY.”

Investors on one hand, but how do manufacturers differentiate their ETF offerings in a category that provides little scope, actually a large scope as we shall see.

After all, how different can be an ETF offered by say Edelweiss to that offered by let say the market leader (in terms of size) SBI on the same index?

The difference comes from the very basic nature of the product offering but before we go into the intricacies of differentiation in ETFs, let us ask the same question in the context of Active Funds, so that we start in a familiar territory.

What causes the Differentiation between say the large-cap products of two different fund houses, say HDFC Top 100 Fund and Nippon Large Cap Fund?

At the core lies the investment process, which in the case of Active Funds, essentially at the end of all the science implies Fund Manager Activism, for she decides what to buy, when to buy and how much to buy. It boils down to the Fund Manager’s call.

And if we look at the SPIVA reports, more often these calls fall apart. Most products consistently fail. As per the most recent annual report by S&P Global, 65 percent of Large Cap products failed to beat the Index in the ten-year horizon. But that’s a different story.

Also, it’s a different story that, both these products (HDFC Top100 and Nippon Large Cap) have similar product features; TER, Standard Deviation, Beta, Sharpe Ratio etc, in fact both the products reported exactly the same Sharpe Ratio of -0.02 in Sep’20. Their Portfolios have significant overlaps and the returns/risk metrics are not very dissimilar. The technology tools available to investment teams of HDFC and Nippon are equally advanced. Furthermore, even though two different entities (#CAMS and #KFinTech) provide the Fund Admin service there is not much difference on operational parameters either. Redemption Pay-outs happen at T+3 in both cases.

The core reliance on the personality of the Fund Manager (think of the star names in the business) to provide the Differentiation in the product offering has deeper implications when we compare the Differentiation parameter not just within ETFs but across the Active and Passive segments. It is not about which is better, but about the differences that exist across.

It will also help us fathom on why some ETFs are just plain ugly, while others are on their way to become Miss Universe, and a few can believe to have reached there.

There are about a dozen ETFs offered on NIFTY. In fact, the ETF story for any Fund House in India follows the natural trajectory of Gold primo, NIFTY 50 seconde, and maybe BSE SENSEX 30 troisieme. It almost is on the same lines as S&P 500 was tracked in the US at the beginning of the ETF dawn. Currently, the international ETF NASDAQ 100 distributed in India is climbing up the popularity charts, thanks to the ever-rising tech stocks and the ever depreciating INR.

The concentration story that we see in the Active space, is visible in the passive space too. The top twenty percentile Fund Houses account for about 85% of the total industry AUM. Similarly, of the total assets of 1 Trillion INR that track the Nifty, the top two Fund Houses account for the bulk of the AUM.

The Central Board of Trustees that administers the EPFO funds constituted from contribution of workforce engaged in India’s organized sector was allowed to invest in equities in 2015. Its allocation to equity markets increased from 5 per cent of its incremental flows to 15 per cent in 2018.

Consequently, NIFTY ETF of SBI MF took off, catapulting the Fund House to the Top of the AUM table in 2020 displacing #HDFC. It is a matter of time when similar institutional players would explore the ETF route for propping up the falling yields off fixed income securities. Whether they would go to SBI or some other Fund House is to be seen. Let us see at some possible decision variables for now that may give an idea on where the fund flow will go.

On one hand SETFNIF50 of SBI has assets of about 75,000 cr INR, on the other hand there are three ETFs in the below 2 cr AUM bracket, the most vintage amongst these three, being the ETF offering of #Invesco. It was launched in Jun 2011, and in a decade has successfully managed to reach 2 cr assets. It is in stark contrast to what Invesco does with the Cubes in the global markets, but we will come to that.

For now, this heavy concentration of assets at the top appears to be unlinked to performance record, and as performance becomes the deciding factor, there may be a change in the Rankings, but, one thing is unexpected to change; the concentration factor.

The rules outlined by Vilfredo Pareto in the 19th century on the landholdings shall continue to hold true, as it is seen in the global markets also where a handful of ETFs control bulk of the market. They control not on the basis of a sovereign decision, but is performance-driven.

Product differentiation in the Passive space, just like in the Active space, is both easy and difficult, depending on where we read the situation from. However, there is a core difference on the parameters that result in the Performance differentiation.

Unlike in a Passive fund, the Active space overtly depends on the aura of the fund manager. The Distributor fraternity through which most of the sales happen is charmed by two things, Commissions & Fund Manager interactions.

It further helps that most of the targeted customers in the Active space are retail investors who easily get enamoured by qualitative factors such as personality, whereas the Passive space is dominated by institutional investors, the kind of people who go by hard numbers and make life miserable for the slightest miss.

As a first filter to evaluate ETFs, let us apply the size criteria.

It is critical, for there is no point in investing, even for a retail investor, in an ETF that has negligible tradability. Products offered by Fund Houses like Invesco Edelweiss and IDFC with assets of less than 2 cr INR would have serious liquidity problems that result in price pollution thereby making it unworthy of investment.

If we look at size as criteria, SBI has the largest ETF on NIFTY followed by UTI. However, when we look at the performance, things don’t seem to be working out. Both fail the second test of expense ratio. A low Expense ratio is no guarantee of performance, but a high expense ratio is most likely to dilute returns for investors, unless proven otherwise.

Incidentally both SETFNIF50 (SBI NIFTY ETF ticker) and UTINIFTETF (ticker for UTI NIFTY ETF) have the same expense ratio, a shade below 7 bps and almost similar tracking 21error of 0.18%. Tracking Error being the third filter.

Now the Tracking Error concept in the case of Passive Funds is a complicated area, (there are further complications when we talk of volatility measures like R2 etc), but in brief we look at the “deviation of the product returns from the index return computed continuously.”

There is another simplistic way of look on how well the ETF has tracked the underlying Index that it is supposed to mirror. The Tracking Difference or the Return Difference.

Let us look at the top ETFs, filtered on the basis of Expense Ratio on the basis of Return Differences, leaving aside the complicated vol measures that are used by Fund Managers and published religiously in their factsheets, that remain unread by most of the investors, for sure no one reads before investing, and uncomprehended by those few who care to read after they have invested. The Factsheet of ICICI Prudential, provides the following details for its ETF product,

Std Dev (annualised): 21.19 %, Sharpe Ratio: 0.20, Portfolio Beta: 1.00

Given that it is an ETF Portfolio, it will be news if the portfolio beta was anything but 1.00.

We somehow tend to be precise in counting the trees but miss the forests by a long shot. The three large Fund Houses, have the same competitive Expense Ratio of 5 bps.

The size of the AMC clearly has its advantage, for operating a Fund at 5 bps on a standalone basis does not make business sense below an AUM size of 5,000 cr.

At 5,000 cr, 5 bps would yield 2.5 cr, half of which would go in managing the costs like Fund Admin, and at the most half that is just about one cr would hit the AMC Income statement.

In this subset, Nippon has the vintage advantage, having acquired the oldest NIFTY ETF that was launched by Benchmark AMC way back in Dec 2001, and had passed through Goldman hands. The age however does not take things very far.

For when we look beyond the Expense Ratio, and at the Return Differences, the performance of all the three ETFs varies, on the core deliverable, that is “to mirror NIFTY returns”. It effectively proves that Expense Ratio should be the starting point for an Investment Decision, not the final criteria.

The case of IDFC ETF with an Expense Ratio of 6 basis points is interesting, it has a tracking error of 0.64. On the other hand, for Edelweiss ETF the problem is in return difference. Besides the bigger problem, that these two ETFs have assets of less than two crore.

The complicated Tracking Error published by the Fund Houses, is in double digits, with ICICI NIFTY of #Pru at 0.33 %.

For those who are unable the comprehend the concept of Tracking Error, for it is indeed tres difficile to make sense of 0.33% or for that matter what is the difference between Tracking Error of 0.33% and Tracking Error of 0.11%. Optically it conveys that 0.11 is better than 0.33 %. Lesser the better, but fails to convey, “how much better”.

There is an alternate way to look at the absolute deviation of the ETF Returns from the Index Returns on periodic basis.

Since Inception, in the case of NIFTYBEES, the difference between the ETF returns and Index returns is at (0.42 %). While the negative aspect is justified, as ETFs have expenses while Index does not have, the high level of deviation is unjustified. However, this deviation seems to be coming under control, if we look at the past one-year track record.

In the past one year, the difference between the NIFTY returns and ETF returns has narrowed down to (0.28%), which still is on a higher side. It is marginally better than (0.29%) of ICICINIFTY and significantly better than (0.35) of HDFCNIFETF. However, as we shall see, all these three are terribly bad figures for Tracking Error in a liquid index such as S&P NSE 50.

Before we look outside, at the global leaders, on their track record, it is worth attempting to find the cause for the performance difference as this itself leads to Product Differentiation in the market place which ultimately gets reflected in the Assets Under Management. It may explain why the ETF of Invesco, launched ten years back, is languishing at Two cr, while ICICINIFTY launched in 2013, has accumulated 1,307 cr.

As stated earlier, in the world of ETF, there is no decision to be made on What stock to buy, how much to buy, when to buy. The Art element of Fund Management is absolutely eradicated. No deep #Equity research is required. No Rocket Science, but there is a lot of elementary science.

Furthermore, within the subset of these three large Fund Houses, there is no difference in terms of the technology tools being made available to the investment team. Thus trade execution efficiency is on par.

Yes, there is the creative art element on the marketing side, but on the investment side, it is absolutely process driven that depends on Process Discipline.

Minute errors (defined as deviations from stated processes) result in Performance differential that reflects in Tracking Error and Tracking Difference. It gets punished mercilessly in the Passive world where institutional investors dominate unlike the sweet forgiving retail investors in the Active space.

This is also the area where we have strong potential for improvement; a big opportunity for a Disruptor. (the earlier article is a good read on this aspect)

To answer the second question, this Process Excellence lends the strategic competitive advantage to ETF Manufacturers for Product Differentiation in the market place. Unlike in the Active space, this area is highly susceptible to traditional quality metrics and improvements can be tracked thereby resulting in continuous shrinking of the deviations, as measured by Tracking Error and Tracking Difference. This is demonstrated beautifully on the global stage.

Let us look at two examples of ETFs on the S&P 500, as beacons for the journey from Good to Great, for these indeed are beautiful examples of Extreme Precision in Process Engineering applied in the world of ETFs. The callipers are used liberally to measure the holes caused by the tracking error.

iShares Core S&P ETF (ticker IVV) launched two decades back, around one year before NIFTYBEES was launched in India by #Benchmark, operates at an Expense Ratio of Three basis points.

The Tracking Error published is at 0.01, compared to 0.11 of NIFTYBEES. The Return difference on a One-year basis is a mere (0.05%) compared to (0.28%) for NIFTYBEES. (source ETF.com)

This sigmatic control on performance to mirror the Index attracts large institutional investors who get stinging fussy with every basis point deviation. Given that institutional investors dominate the ETF space, the emphasis on performance is merciless. It eventually resulted in the ETF accumulating 209 Billion USD. Approximately 40 Million USD in revenues for the Fund House.

The second example is from the Vanguard stable (ticker VOO) which again operates at an Expense Ratio of 3 basis points and a Tracking Error of 0.03. The Return Difference on a one-year basis between VOO and S&P 500 is at a mere (0.03%) and since Inception the Return Difference is at a mere (0.04 %).

The result being VOO accumulated 157 B USD in assets.

The journey for ETFs in India has just started as Assets under ETFs now account for about Ten percent of total industry assets. Investors are flocking to Depositories to manage their ETF holdings. The Government has been pushing ETFs ever since the first CPSE divestment in 2014, then the EPFO investments in NIFTY ETFs came, followed by more CPSE tranches and the Bharat Bond recently.

It will be sometime before the Active mindset of the Fund Houses gives way to the Process Engineering mindset required for managing ETFs. Thereafter there would be no stopping of the explosion in the ETF space, in the same manner as was seen in the US market in the past decade.

Until then investors in India do have the option of investing in IVV and VOO of the world. Many Robinhoods have crossed the seven seas for Money driven by the principles of Fluid Mechanics in search of the most efficient investment products, transcends national borders.

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