The Mutual Fund Show: Know When And How ETFs Are Good For You

ETFs are cheaper mode of investments. Read to know how to invest in them and rebalance your portfolios.

A gas flare burns as a truck is seen in the rearview mirror of a car. Photographer: Angus Mordant/Bloomberg
A gas flare burns as a truck is seen in the rearview mirror of a car. Photographer: Angus Mordant/Bloomberg

While investing in exchange-traded funds, people must exercise patience and not frequently look in the “rearview mirror”, especially for long-term gains.

That’s according to Chintan Haria, head of product development and strategy at ICICI Prudential Asset Management Co. In this week’s The Mutual Fund Show, he suggested that such investments must be apportioned to different ETFs—gold, equity, debt and REITs—and the portfolios reviewed annually.

“ETFs are democratisation of the financialisation wherein one doesn’t need to have big bucks to buy the entire index,” he said, adding such investments give ease of buying in a way one could purchase a single stock or equity.

Amol Joshi, founder of PlanRupee Investments Services, however, said he prefers index funds over ETFs because of the depth of liquidity available. Joshi suggested ETFs could comprise around 10% of an investor’s overall portfolio.

Watch the full show here:

Here are the edited excerpts from the interview:

Chintan, what are ETFs? How do we go about investing in them?

HARIA: So, to put very simply, we are all used to mutual funds and the active mutual fund piece I think everyone would have been investing in wherein the fund manager picks and chooses the stocks on the basis of the objective which is laid out in the scheme information document.

An ETF or an index fund is exactly the same in terms of how the investor would invest or take out from a theory perspective, but the only difference is that instead of an active fund manager, buying and selling stocks on a regular basis or on a daily basis maybe, the ETFs or the index funds in India are passive funds, which essentially mean that they follow a particular index. As far as the index funds are concerned the investment and redemption is also the same like mutual funds, but in ETFs it’s similar to a stock, when you go to the exchange and you can basically buy even a single unit.

To put it very simply, you can get an entire basket of let’s assume Nifty 50 or Sensex 30 by buying one unit of that ETF. It’s also the democratisation and financialisation of India wherein you don’t need to have big bucks to buy the entire index as you can buy one unit on the exchange. That’s essentially what ETFs are, it’s giving you ease of buying a complete basket of an index in a very simple manner on the exchange much like you would do in a stock or in equity.

There are large-cap funds wherein they say that there is a fund manager who will be able to generate alpha over the benchmark, which is the index usually. So, if that is the case, why should somebody look at ETFs?

HARIA: Clearly in India, especially with the long term if we have seen the funds which are the active funds—they have been able to generate alpha, they’ve been able to provide alpha but we are seeing India increase its financialisation. We’re seeing so many more people investing in finance and so one size fits all and one particular product category may not probably fit the need. You need to have probably a best of everything.

I am not for one saying that active fund management in India won’t be able to generate alpha. Yes, 2018-19 and 2020 have been difficult years because of the polarisation and with the top 10 stocks are up 80% while the rest of the market is probably flat or negative. So, it’s been something which happened in 1999, which happened in 2007, probably is getting reflected right now but that’s not how it will always be. So as an investor much like you need to have a balanced diet, you need to have all kinds of food on your plate, similarly you will have active funds as well as passive funds in your overall basket and like you have equity, debt, real estate and gold. Similarly, active plus passive will be there. It is up to you how well you are informed and how you can create a basket or of course a financial adviser can help you to get the best of both worlds. So, I wouldn’t say one for the other, I would say that both are important, and both have a role to play for the investor over a period of time because you just don’t need alpha times you sometimes need beta too. It’s essentially being allocated towards equity and that equity allocation as a first step, can be easily added to a simple, plain-vanilla large-cap oriented ETF for most investors.

It’s not only about equity when you’re building a portfolio, but also about having various asset classes, and I reckon that ETFs give investors the choice to at least have all kinds of financial assets or most kinds of financial asset exposure. Can you talk a bit about that and talk about how does one build this low-cost portfolio?

HARIA: So, why low cost has been highlighted many times in this conversation is because yes, that is one of the three criteria because you’re following an index. So essentially the fund management portion is not there, you’re following an index and hence the costs are low. That’s globally the trend, and in India also it’s catching up. In fact, in 2015-16, when provident funds were allowed to invest in ETFs, that’s when the ETF journey in India kind of exploded. In the last four to five years, we’ve seen a lot of more products available in the ETF basket, with people also being a lot more aware and with digitalisation—the Zerodhas of the world, etc., everyone’s coming onto the bandwagon in terms of having an easy access, which today’s millennials or the youngsters can immediately invest in, ETFs are catching up as an investment option.

Now how much or what are the options within ETFs as far as asset classes are concerned. So maybe up to two years back, the only option which we had was equity and gold. Now, if we see debt as an option. But I’m sure you will see a lot more options coming up in these three categories and sooner or later maybe as India evolves, we may have other commodity ETFs and REITs in which ETFs are there as well. So, it’s a wide landscape which is possible.

Currently, as I see it, bulk of the AUM is in equity ETFs, followed by gold. Debt is picking up big time, especially after the government-backed Bharat Bond ETF.

I think the budget also did something for gold ETFs, right?

HARIA: As far as the budget is concerned, I don’t think they did specifically anything for the gold ETF per se, but they did reduce the import duties which essentially meant that it is cheaper for you to buy gold. So, gold prices have fallen and it’s one more opportunity. In fact, if I have to compare the last six months it’s been an equity rally, a risk-on rally. So, gold has come down, I think, from a peak of Rs 56,000 in India to Rs 48,000, while equities then were around 10,000-11,000 on the Nifty and have reached around 15,000.

So, roughly there’s 35-40% underperformance of gold. And, this cut in import duty has further made gold more attractive in terms of a diversification asset class.

So, like we say, 5-10% of assets, if you’re have it in gold, it is not a bad idea. Traditionally, it was in physical gold that people used to invest in but we’ve seen because of the lockdown and because of the newer generation wanting to invest in financial assets, gold ETF is also one of the preferred choices which investors are investing in.

Assuming that the mutual fund side is taken care of, if I’m trying to build this portfolio of ETFs, how should I go about it? What should I keep in mind because, according to ICICI Prudential, plain-vanilla ETFs have the lowest expense ratio and smart beta funds have slightly higher. If I want to use ETFs also because of costs being a big factor over a 20-year period, how do I go about it?

HARIA: The first step should be what should be my asset allocation. I think we as an asset management company, we were pioneers in that category and I think we truly believe that asset allocation is the way to long-term wealth creation with lesser risk and you’re never basically chasing the market when you’re in asset allocation. So, the first step is, based on your risk profile, create an asset allocation.

Now 80% equity may be right for you, 40% equity may be right for me. Whatever you’re comfortable first decide that. Now once you’ve decided that okay 40% in equity and the rest 60%, I’ll want to be in debt and gold, that 40% which is an equity, whether I want it to be in smart beta, whether I want it to be in large-cap ETFs, whether I want it to be in active mid cap, multi-cap funds. Of course, you have index funds around the small cap and you have mid-cap ETFs too. So, there are a wide variety of ETFs but the first part is asset allocation.

Now, if you want to build a low-cost portfolio, it’s very simple. Suppose you have 50% equity, 30% debt and 20% gold as your chosen asset allocation. The 50% which you have in equity again you can break it up into let’s say 40% in large cap, 60% in flexi-cap. So, you have that option where you select that. Then you have the debt portion, you have liquid ETFs where you can invest your debt portion to start with and then as and when the market gives an opportunity and you want to increase your equity allocation, you can liquidate your liquid ETFs and move into equity ETFs.

Gold ETFs maybe 10% maybe 20% of your allocation. With gold ETFs, you can simply buy and hold. Again, the most important aspect, after one year, suppose markets have done very well and your allocation changes, you need to rebalance it maybe once in a year and because of the favourable taxation which equity ETFs have you can basically invest or book profits also and move to debt as and when the opportunity arises. So, I think it is like you said, a low-cost way of asset allocation in the long run and today you have all the products and the building blocks in place on the ETF side—be it gold, be it liquid ETFs, be it large-cap ETF or be it mid-cap ETFs. I think, there are pretty much a lot of options and you mentioned about smart beta, that’s slightly more technical and slightly more for the involved investor but we are seeing a lot of high net worth individuals and family offices tilting towards a low-volatility products. Higher risk-adjusted returns have essentially lower volatility and higher returns.

Any caveats or anything that should be kept in mind before doing this?

HARIA: The first and the most important caveat is don’t look at the rear-view mirror. Today if someone has seen that from March 2020 equity markets are up 100% and today you go and invest maybe 50% of AUM because Chintan is saying 50% of equity, that’s not the right model. It’s something which you apply consistently, and you choose the right opportunity to do so.

I would say that don’t look at the rear-view mirror while you invest, that’s the first point. The second point is patience pays in the long run as far as equity investing is concerned, and that applies to equity ETFs as well. So, the longer you keep, the better it is from a compounding perspective.

These are very simple things which you would have heard probably a 100 times but very difficult because of our greed and fear. I myself in March, if I have to look back, I would have never expected markets to do what they have, despite me knowing that the central banks are going to come up with a bazooka so to say and we are where we are. Today with Sensex at 50,000, I can’t forget that the market has gone up 100% and you need to be cautious as well as careful not to increase equity exposure when markets have doubled because that may not be the right thing. Having said that, what equity exposure, you should be at—that’s something which clearly you need to work with your financial adviser and have a plan, and ETFs like I said, they have a very big role in adding to your overall portfolio mix because of their low cost, because of their ease of execution and in the long run, they’ll help in wealth creation as well.

Amol, how do you rate ETFs in the portfolio? What percentage of an investor’s portfolio should ideally in be these ETFs of any nature?

JOSHI: I believe, for ETFs these are probably early days, including for product depth as well as market liquidity. What I’m trying to simply say is that there are better alternatives available. I think in the previous conversation, we heard many times about the low-cost advantage of ETFs, it is undeniable, ETFs truly are one of the lowest cost mutual fund products. Keeping that advantage aside, you still have comparable products. So, I would say, an index fund which is also available to you at a 10-15 basis points cost for the year, these index funds probably are a better substitute for ETFs. I think we will touch this topic in detail, probably in the later part of the conversation.

But suffice to say, ETF if it’s a unique offering, can probably account for a 5-10% of your allocation.

Until a few years back, this allocation probably was best taken in gold ETFs because gold ETFs typically had lower costs and gold savings funds which are in a mutual fund kind of a wrapper or construct, these had costs in excess of 1- 1.5% but after the emergence of sovereign gold bonds, I think the case for ETFs probably has got diluted over there as well. Suffice to say, ETFs, keep them on your radar, with probably 5-10% of the average.

Why are you saying that index funds are a better option than an ETF?

JOSHI: The reason why I say that is liquidity or depth of the liquidity available. So, ETF again, the previous conversation was a great primer for all of us. ETFs as we all know are exchange-traded funds. You cannot buy these funds as a retail investor and as a small to medium sized investor. You cannot buy these funds directly from the fund house. Typically, what you are used to do for your Rs 1,000 SIP or for your Rs 10 lakh purchase investors across the spectrum, you typically submit your purchase, as well as redemption application to the fund house. The fund house, during the purchase allots you the NAV and units for that particular working day, and during redemption you get the closing NAV of that particular day. By closing NAV, I mean, there is only one NAV per day. Now when you buy ETFs and ETFs being exchange-traded funds, you’re essentially buying from other ETF sellers, your counterparts on the other side of the terminal or market makers as a retail investor. Most of the times we have noticed that during a buy transaction, if the closing NAV of that index of that day is let’s say Rs 43, many times we have found out that ETFs are trading at a much higher valuation and sometimes as high as 1-2%. During sale, of course, the boot is on the other foot to use the sale. Now, during the sell transaction, if Rs 43 is the fair NAV during that time, you are probably going to end up selling at something like Rs 42 or Rs 42.5 or Rs 42.7. So, the cost factor that drives many people towards ETF, if you do not get a fair buy price and a fair sell price, then it’s not just that the cost advantage evaporates, you are likely to actually make losses. Now I’m not talking about loss of capital value, I’m talking about the loss compared to if you would have got the fair value for your buy and sell transactions.

Do you really think that market depth would have such a profound impact on returns from this instrument?

JOSHI: Yes, why not. Let me bring one more angle over here. Probably last month, about one more time the data was released and 50% of the investors have a holding period of less than two years in equity mutual funds, in India. Now, imagine half a percent or a quarter percent of the premium you pay during a buy transaction, half a percent or quarter percent premium that you lose during the sell transaction. So, overall, your hit is somewhere between half and one percent. Now, if you are a one-year or a two-year horizon investor, which 50% investors are going by the data, then your annual hit is somewhere to the extent of a 0.25% and as I mentioned, this is pretty large. Now if your ETF has a 3 paisa expense structure and instead of an ETF, you invest in an index fund, I can tell you that there is a Nifty Index Fund available at 10 basis points or 10-paisa cost structure, then the math very clearly says that you will probably take a 10-12 paisa hit per annum. I don’t think you should do that. There are other aspects—most people use mutual funds for the simplicity that it offers. If you are to continuously monitor your buy and sell price as well as to the transaction in demat. Most of the people are not used to buying mutual funds in the demat form, then I think compared to all of this, the cost advantage largely gets negative.

Let’s talk about underperforming large-cap funds. What should investors do with some of these? One of them that stood out was DSP 100. What’s happening with this fund? Any reasons as to why it is underperforming and what should somebody do if she or he has a subscription or has this fund in the portfolio?

JOSHI: DSP Top 100 being one of the largest schemes with assets under management in excess of Rs 2,500 crore, it delivered close to 13% of the five-year CAGR. As against that, the top scheme had around18% of five-year CAGR. That is 5% CAGR over a five-year period that is significantly large, as well as the benchmark of BSE 100, the total return index, that benchmark probably delivered around 3-4% or higher. Now, in my analysis of this fund, I will have to take you exactly one year back in time. So, during March, the fund had 50% of exposure towards financials—so banks and financial services put together. In fact, it was 50.50. Now we remember very well over the last one year, there have been two phases of underperformance for the banking sector. The Nifty took off from the bottom of 7,500 and banks took close to one to two months of underperformance to catch up with the Nifty. Again, during the pre-budget selloff the bank sold off quite substantially and after that, the banks have picked up. What the fund has done is that it shed banking and financial exposure from 51% of March 2020 to hardly 28-29% or so. Hence, I would say that the sectoral allocation probably was something that contributed to this underperformance, that’s number one.

Number two, you also have to understand what kind of a fund that you are investing in. A top 100 clearly says that fund looks for two factors. One is growth drivers and second one is valuation comfort or valuation support. So, the fund kind of also doesn’t invest in out and out quality or out and out growth companies. Here I’m talking about something that completely runs away, typically, that is the momentum stocks, this fund has less exposure to those because of the construct of the fund that mandates it to have some kind of a valuation comfort. Now what investors should do is, let’s go back to the returns. The returns are close to 13% five-year CAGR, these are by no stretch of imagination, are not low returns. The only thing is that the fund has probably not done well compared to the benchmark. Now the standard modus operandi what you should do when any fund underperforms the benchmark is, you have to go in detail about why the fund does so. So, either you or your adviser will do this, you have to look at sectoral allocation and if the sectoral allocation is not up to your liking, ideally the fund manager decides that, but if you have your own view, then probably there is a case to switch out of the fund. Now we have recently seen the coverage about a couple of large-cap funds, a couple of blue-chip funds that had large exposure to the largest PSU banks. Now, those PSU banks haven’t really done well, barring the last few weeks. In last few weeks, it has given chart-busting returns. The stock price has probably doubled in last few weeks or a couple of months, and funds which were underperforming all this while, over a one month or one quarter time horizon, are suddenly back into the limelight. So, this is very tricky, I would say, as long as the fund does a good job of managing as per the fund manager’s strategy, which is widely declared, and it delivers something over and above the benchmark, I think you should stay invested. If not, then you probably have to look for other options.

Let’s think of funds which are good from an investing perspective from a small variety of funds that you might be recommending to your clients. Which is the one that from a size and timing perspective looks good to invest in, and why?

JOSHI: We are all used to talking of timing and using the terminology in equity, which is based on valuation and based on your targeted returns. Here I want to use the timing terminology for debt. Now it’s not timing of entry or exit, it is timing of the year. So, we are somewhere in the middle of February. In a short while, one and a half months from now, you will go to the next financial year. What’s so unique about it? The thing unique about it is if you invest in your chosen debt fund, obviously, when I say chosen, I’m talking about something that fits your investment horizon and something that fits your rating profile. So, if you invest in a debt fund, only by investing into it for three years and a couple of months, you will be able to get benefit of four indexations. Now four indexations—I’m sure we have discussed this indexation topic many times this is one of the tax advantages that debt funds or fixed income mutual funds enjoy.

Now coming to the actual fund offering, I want to talk about IDFC Corporate Bond Fund. That’s what I would recommend to somebody who has three years of an investment horizon. The IDFC Corporate Bond Fund employs a roll-down strategy. So, the fund was launched in 2016 and during the starting phase, it bought the AAA-rated papers of four-year maturity that obviously matured in 2020. When the fund started it had a yield-to-maturity of 8.25%. So, YTM minus expenses is somewhere around 6.75-6.90 kind of return, and the fund delivered exactly that. YTM minus expenses is a much talked about and a less understood concept. It doesn’t work in all the funds because there could be other factors like credit event or an interest rate movement. These two factors can get upset and it doesn’t, however, get upset if it’s a roll-down strategy and if you do not have any credit event. This fund being a 100% AAA-rated fund avoided all of that in 2016 to 2020 period and delivered around 7.75-8% CAGR.

Currently, if you have a three-year horizon, you will be able to invest into this [IDFC Corporate Bond Fund] and get four indexation benefits. The fund currently and completely as arrived from the beginning and today is 100% AAA strategy. I would say if you’re a risk averse investor with three years of investment horizon and looking for debt allocation, I think this is the fund that you should look at.

Just a disclaimer — by recommending this fund, you or your house, do you have any commissions coming out of the fund house in any fashion whatsoever?

JOSHI: I am a mutual fund distributor. Investors who invest through us there is a commission factor. However, viewers who are watching can probably take help of their advisers. If they’re investing on their own with their research and if any inputs are taken from here and if they are investing in direct plans, then there is absolutely no commission involved for the investments.