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Exchange-Traded Funds (ETF) – Performance, Risks, And Opportunities

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Exchange-Traded Fund (ETF)

Exchange-Traded Funds (ETFs), as the name suggests, are index funds that trade on the stock exchange

By: Tavaga Research

Exchange-traded funds or ETFs are passive funds that are similar in many ways to a mutual fund except the fact that they can be purchased and sold on a stock exchange. The underlying investment funds are generally invested in stocks passively mirroring the composition of indices. There are also bond and commodity ETFs now becoming available as the ETF product offering has gained traction since the early 2000s. Eg: A Nifty 50 ETF will have the underlying securities that are identical to the Nifty 50 index. ETFs are primarily bought to get benchmark market returns. It’s a great product to buy, especially in India where the market returns (Nifty 50) have averaged around 13% p.a. (annual compounding) over the last 15 years.

In India, ETFs are structured under the mutual fund umbrella as a type of Open-Ended Mutual Fund scheme, with a significant difference. ETF units can be traded over a stock exchange at any point during the span of trading hours and are held in your demat account after settlement. As a result, ETFs come only with expenditure on the brokerage fee whereas mutual funds also charge commissions and other fees. The issuance/redemption of ETF units may carry some costs — but an ordinary retail investor who only trades in and out existing units on the stock exchange would only bear the brokerage charges and impact cost.

What are the advantages of ETF?

  • Lower Fund Management Fees than most mutual funds. MF expense ratios are between 1-2%.
  • No Trailing Commission for Distributors in ETFs as they are traded on the exchange (unlike in mutual funds).
  • ETFs have features similar to a stock – They can be purchased on margin and even sold short
  • ETFs offer diversification benefits as they provide an investor with exposure to stocks from various sectors and sizes

ETFs in India are listed on both the NSE as well as the BSE. To be able to purchase an ETF, one must have a demat account and a depository account (with NSDL or CDSL) linked to it. In a conventional pattern, one would have to set up a demat account by going through the various stages of documentation either with their bank (that have a securities trach) or with any other company serving as a broker in the market.

Key Players in the Exchange-Traded Funds (ETFs) Market

ETF Sponsors

The sponsor creates and administers the Exchange Traded Funds. The sponsor is responsible for the selection of the underlying index and authorized participants (AP) associated with the ETF. The sponsor issues ETF shares in lieu of the shares deposited by the AP.

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Authorized Participant (AP) or Market Maker (MM)

APs/MMs are large institution players. They play a primary role in providing liquidity for secondary sales and in the creation/redemption of the ETF units. When new ETF units are required to be created, the AP buys the shares that make up the underlying index and deposits them with the sponsor. In turn, the AP collects the ETF units. The sponsor can appoint multiple APs for a given ETF.

Investors

Investors could be individuals or institutions that trade in the ETF units. The smaller players trade in the secondary market. On the other hand, larger players generally trade ETF units in the primary market or through “in-kind” operations. Investors may use ETFs for investment, trading, or arbitrage.

Creation and Redemption of ETF Units

ETF Creation and Redemption Process
Source: Tavaga Research

Transacting ETF Units

Buying ETF units

One way to acquire ETF units is by purchasing them in the secondary markets. Similar to stocks, these can be purchased from other investors who are willing to sell. This mode of purchasing is true for all kinds of investors in the ETF.

However, large investors like authorized participants and institutions can acquire ETFs units through a process called “in-kind” creation. In this, the large investors deposit the shares that constitute the index, to the sponsor of the ETF fund. The sponsor in turn issues the ETF units termed as creation units. This is similar to the shares issued at the time of the IPO. However, the “in-kind” creation process can happen multiple times as long as the investors deposit the shares of the underlying index.

Selling ETF units

One way to sell ETF units is by selling them in the secondary markets. Similar to stocks, these can be sold to other investors who are willing to purchase. Additionally, large investors can sell ETFs units through a process called “in-kind” redemption. In this, the large investors deposit the ETF units to the sponsor of the ETF fund. The sponsor, in turn, returns the shares that constitute the underlying.

Net Asset Value (NAV) of ETF

NAV of the ETF is the total value of the assets in the fund, including the underlying securities and cash, excluding the liabilities and dividing by the number of ETF units outstanding. The NAV of the ETF is primarily used for accounting and measuring the premium/ discount with respect to the price. The redemption mechanism of the ETF ensures that the difference between the NAV and price is minimum. The price of the ETF should generally move around the NAV of the ETF, otherwise, it would spark arbitrage opportunities from Authorized Participants.

Measuring Performance of ETF

Tracking error

The goal of an ETF is to track the performance of the underlying benchmark. The tracking error is a measure that looks at the deviation of ETF returns from the benchmark returns. Lower the tracking error better is the replication of the benchmark returns.

Expense Ratio

The ETF is passively managed since only the securities of the underlying index have to the replicated in the fund portfolio. When standard indices (like Nifty, Sensex, etc.) are used, then the overhead is just the administrative cost of purchasing securities and maintaining the portfolio. Hence given a particular benchmark being tracked, the lower the expense ratio, the better for investor returns.

Risks associated with ETFs globally

With positive global trends in the prevalence and growth of ETFs as investment vehicles, there arises a need for a closer assessment of the risks involved with the way ETFs function

The price of an asset is a factor of two components. One component is the asset-specific factor, also known as the idiosyncratic factor. For example, a share as an asset has idiosyncratic factors based on the company’s attributes, strategies, and financials. The second component is the systematic factor that is common to all the asset classes. Systematic factor arises from market risk, which stems from sector trends, market volatility, interest rates, Government policies, etc. The beauty of asset-specific factors is that it can be diversified away.

ETFs are designed to create well-diversified, low-cost portfolios and therefore eliminate the asset-specific risks. Fund houses purchase negatively correlated assets to offset an adverse movement in one asset by a favorable movement in another. ETFs also provide access to otherwise inaccessible markets and thinly traded assets. However, ETFs sustain exposure to systematic risk, which cannot be diversified away.

  • ETFs influence the majority of trading volume in geographies where passive funds are more prominent than others. For example, passive funds own more than half of US equities. In the case of a panic situation, ETFs will reflect a significant portion of the activity.
  • ETF issuing firms are limited to a countable few, showing market concentration.
  • ETFs are created or redeemed by authorized participants, which are also the market makers for ETFs. An authorized participant has no obligation to facilitate the creation or redemption of ETF units and may step away in stressful times.
  • ETFs contribute to end-of-day volatility as the fund managers have to rebalance the weights of securities in the fund to match that of the tracking index. Such trading distorts information-based trading.
  • ETFs face rebalancing risks for illiquid and inaccessible markets.
  • ETFs, just like shares, can be sold short on the exchange, which may lead to a build-up in large short interest.
  • Not out-performing the index as ETFs usually track the index itself.

Global trends

ETF assets globally have experienced a compounded growth rate of approximately 17 percent over the past ten years ending in 2019. In August 2020, ETFs/ETPs experienced a net inflow of $55,186mn. Of the assets grown in August 2020, equities and fixed income accounted for the majority of the inflows. 

Global ETF growth
Net Inflows in August

The Asia Pacific (APAC) and Domestic Trends

Of the US$ 7 trillion in ETF assets globally, the APAC region accounts for a meager 10 percent. Japan contributes to the majority of the ETF assets in the APAC region. The Bank of Japan has a massive 8 percent stake in the equity markets via 80 percent investment in the country’s total ETF assets.

APAC ETF Assets

What is impeding the growth of ETFs in the APAC region?

  • Intermediaries involved in the functioning of ETFs charge a commission from the investors in the form of brokerage. However, ETFs in other developed markets rely on fee-based arrangements. 
  • Investors welcome mutual funds or other actively managed equities more than ETFs as confirmed by the trends.
  • Funds are limited in size and face persistent illiquidity.
  • Tax incentives to encourage investors are absent in APAC economies.

The Indian market is still in the stage of infancy due to investors preferring mutual funds to ETFs. Active equity AUM, such as mutual funds, is prominent to the extent of 80 percent share in Indian markets as compared to passive equity as of July 2020. However, passive equity has witnessed a higher growth in the last three years, showcasing 19 percent growth in July 2020. Active and passive equity funds still make up only 8 percent of the Indian market, reflecting the massive growth potential in the offing if compared to the global market size.

Under passive equity, ETFs have outgrown index funds by a landslide over the past five years. ETFs took off when the Government kicked off their disinvestment programs in 2015 using ETFs as the chosen investment vehicle.  

Passive Equity Growth in AUM

ETFs, as a form of passive equity, are concentrated in Nifty and Sensex, accounting for approximately 65 percent of total ETFs. Government Equity and Debt ETF is 20 percent of total domestic ETFs. Gold ETFs are striving to gain visibility among other popular choices in the Indian markets.

Retail participation in the ETF market is a small fraction of the overall activity. The corporates possess the maximum share of investment into ETFs. As per the recent data by AMFI for August, ETFs and index funds continue to witness net inflow of funds as investors have poured in money into passive equity schemes. On the other hand, actively managed funds have lost their shine during this contractionary phase of the economy.

The ETF market has to be significant in size and proportion to pose a systematic threat to the economy. Indian ETF market at the moment is away from a systematic failure and offers lucrative investment opportunities.

A list of ETFs in India, along with their performance:

List of ETFs along with their performance
Source: AMFI, Tavaga Research

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