Why haven’t innovative ETFs picked up in India like they have in the US?

Despite mergers and acquisitions having taken place regularly in the Rs 6.75 trillion Indian mutual find (MF) industry over the past decade, there was something unusual about Goldman Sachs Asset Management Co. Ltd’s acquisition of Benchmark Asset Management Co. Ltd. Launched in June 2001, the 10-years-plus fund house, with assets of Rs 2,935 crore, was India’s first fund house to focus mainly on passive schemes, especially exchange-traded funds (ETF). Launched with good intentions—to avoid fund manager’s risk and offering a low-cost option to investors—Benchmark AMC remained largely one of India’s smallest fund houses till date; ranked No. 26 out of 41 fund houses, in terms of its assets under management. Eventually, they got sold out. While poor distribution network and sponsor’s disinterest are the whispers on the street, the question most investors are asking is: Do exchange-traded funds (ETFs) work in India? And can stand-alone ETF fund houses work in India?

What are ETFs

ETFs are passively managed schemes that invest their entire corpus in a basket of securities, such as equity shares. They are not meant to outperform their benchmark indices; they are supposed to track it passively. Since fund managers are not involved in managing these funds they work on an automated mechanism these funds are meant for those who like to avoid the fund manager’s risk. However, unlike index funds (also passively managed) that work like any other MF scheme and buys and sell securities from the stock exchange, ETFs have a different mechanism.

The fund house appoints market makers in the stock market who buy the basket of securities (such as all the scrips of the market index on which, say, an equity-oriented ETF is based upon) and hand it over to the fund house, in exchange of a certain number of units. This process is called unit creation, whereby ETF units are “created” in exchange of a basket of securities. The market maker then breaks up these units and sells them separately on the stock exchange. Investors can then buy and sell these units from the stock exchange.

Why are ETFs superior to index funds…

Since a passive fund, such as an index fund or ETF, tracks the market passively, you would expect it to give the same returns as that of its benchmark index. In reality, they don’t. The difference, called the tracking error, is caused because of the cash component that an index funds holds, and also when the fund manager buys and sells the stocks (to align with the underlying index) and pays brokerage on them. The fund’s expense ratio (they can charge a maximum of 1.5% a year) also adds to the tracking error.

But here’s why an ETF’s structure is superior to that of the index fund. Though your index fund manager is typically mandated to hold at least 90-95% of the portfolio in equities (and the rest in cash), there have been instances when your fund manager has held more cash. Inevitably, your fund manager has the power and control to change your scheme’s asset allocation. This is also mainly why Krishnamurthy Vijayan, chief executive officer, IDBI Asset Management Co. Ltd that manages only index funds, said that he recruited ex-dealers and not ex-fund managers to take care of index funds at his MF

Are ETFs liquid enough?

Since only large investors, such as market markers whom the fund house appoints, can “create” and “redeem” units with the fund house, your only chance to buy and sell ETFs is on the stock exchange. Hence, liquidity is important. Some ETFs, like those typically from Benchmark AMC, enjoy good liquidity. For instance, the average trading volume of Benchmark Nifty BeES was 113,000 units a day so far in 2011, 89,463 units in 2010, 145,000 units in 2009 and 72,018 units in 2008.

However, not all ETFs enjoy good liquidity. Sensex Prudential ICICI Exchange-Traded Fund (SPICE), for example, has consistently suffered from poor liquidity. Only 81, 151 and 207 units were traded on average in 2008, 2009 and 2010, respectively. On 119 of 252 trading days in 2010, not a single SPICE unit was traded. On 46 days, less than 20 units were traded. “Since actively managed funds have outperformed ETFs, we have not been able to give much attention to SPICE. In India, fund managers have managed to outperform benchmark indices, as against the developed markets. Even ICICI Prudential AMC’s actively managed funds have done much better than our own passive funds”, says S. Naren, chief investment officer equity, ICICI Prudential Asset Management Co. Ltd.

Fighting for shelf space

Though India’s first ETF house got sold out, market experts believe that this is not necessarily a bad sign for passively managed funds in India. As per the ETF landscape report released by BlackRock Inc., an US-based asset management company and the owners of iShares ETFs (world’s largest ETF provider in terms of number of products and assets under management with a 44.1% market share) ETFs have grown by 33.2%, compounded annually, globally in the past 10 years and 26.1% in the past five years.

In the US, MFs witnessed a net redemption (more money went out than came in) of $278.3 billion, against a net sales (more money came in than went out) of $85.9 billion during the first 10 months on 2010. With the US ETF industry having crossed the $1 trillion mark on 16 December 2010 (it took the industry 18 years to reach this milestone), the US MF industry (excluding ETFs), took 16 years to reach the $1 trillion mark.

What should you do

Though I believe that ETFs are good products and make a good way to construct the core of the portfolio, you don’t need to invest your entire corpus in ETFs especially if you do not have a demat account.

Small retail investors who are wary of accessing stock markets will find it more comfortable in filling up a form, the traditional way, and investing in index funds. But since ETFs enjoy low tracking error (they track their benchmark indices more closely, on average, than index funds) and are low cost products, at least one ETF in your portfolio bodes well.

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