ETFs: The best of both worlds

After the market crash and the unpleasant firm-specific risks witnessed in the recent past, the retail investor is faced with a vexing question: 'Where should I invest my capital to generate safe and sufficient returns in the long run?' Considering the demographics of our country, the retail investor base is focused on savings and is scouting for ways to allocate capital to generate a risk-adjusted return in the long term. In this context, they realise the benefits of exchange-traded funds (ETFs), an instrument that enables a complete market view instead of a stock-specific investment.

ETFs combine the advantages of both index funds and stocks. They are liquid, easy to use and can be traded in any quantity, just like stocks. ETFs provide diversification, market tracking, transparency of an index-based mutual fund and come at low costs. In the Indian context, the average expense ratio of an index fund is 1.3 per cent, while ETFs such as Nifty BeES are available at a ratio as low as 0.5 per cent. These are less than the expense ratios of actively managed funds, which hover around 2.25 per cent.

Worldwide, ETFs have seen a phenomenal rise since they were introduced in the 1990s. Their assets under management (AUM) have surpassed a trillion dollars, with about 2,200 types of ETFs tracking various indices across asset classes. There has been a steady growth in their numbers (200) and AUM ($60 billion or about Rs 27,000 crore) in the Asia Pacific region too. The Indian ETF space has also gained traction in recent years. The AUM of Indian ETFs is at $600 million (about Rs 2,700 crore) and is growing.

For an investor looking to gain exposure to a specific asset class, it is convenient to buy or sell the entire market using these instruments. In a sense, these can be called 'Zen' instruments. For, after making an investment, one can be at peace with volatility because one is no longer dealing with a specific company.

An appealing feature of ETFs is their presence across asset classes. In India, a gold ETF such as Gold BeES has seen great demand from retail investors. If one goes by records, gold returns have shown negative or almost zero correlation with the Nifty returns. Thus, a gold ETF is seen not only as a hedge against equity exposure but also inflation. The presence of gold and liquid ETFs gives the investor an opportunity to diversify.

Various studies have shown that asset allocation accounts for about 90% of the portfolio performance in the long run. Asset allocation using ETFs has become one of the best ways to construct a portfolio, mainly because of the transparency, liquidity and low cost of funds.

Asset allocation funds are immensely popular worldwide as they save the investor the trouble of tracking various sector-specific investments. In India, one can think of asset allocation among fixed income, equity and commodity ETFs. Based on the risk an investor is willing to take, a combination of ETFs provides better risk-adjusted returns compared with a particular stock or sector. With the ETFs gaining ground, there is a good possibility that they will become a dominant investment tool in India.

Sanjiv Shah is executive director of Benchmark Mutual Fund