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The Rise of Exchange Traded Funds in India

Editorial Intern, TRANSFIN.
Nov 11, 2020 11:02 AM 4 min read
Editorial

It’s not a stock… it’s not a mutual fund…it’s an ETF!

Bringing together the ease of trading shares with the diversity of a fund, Exchange Traded Funds, or ETFs, are gaining traction as a favourable source of investment. In the past five years, India’s ETF industry has seen its volume grow by a factor of 30. A combination of government policies and acceptance on part of investors has fuelled interest in ETFs now more than ever before.

Let’s find out what all the interest is about…

 

What are ETFs?

ETFs are a type of fund where investors pool in money to invest in a basket of stocks, commodity and/or debt securities that are listed on the stock exchange.

ETFs are an opportunity for investors to be exposed to a variety of stocks at relatively lower costs. They could consist of a single type of security or be a combination of several securities. ETFs are traded at market-determined prices, much like shares.

The Securities Exchange Bureau of India (SEBI) manages ETFs and mutual funds under a common regulation.

 

How do ETFs Differ from Other Forms of Investment?

The main difference between ETFs and other pooled investments like mutual funds is that ETFs can be publicly traded (akin to shares or bonds of individual companies) in blocks or “creation units” in spite of having a fund structure. This means that each fund consists of a portfolio of securities which come together as a block. Think of ETFs like a gift hamper, with each gift representing a type of security. Each item of the hamper are “gifts”, but they can also be gifted together in the form of a basket.

Unlike mutual funds which are bought and sold at the end of a trading day, ETFs and shares are traded through the day. Their prices adjust according to the buying and selling activity of the securities they represent. Since ETFs reflect the price movements of the securities they comprise of, they don’t need to be actively managed by a fund manager. This is one of the reasons ETFs are cost-effective.

Another feature of ETFs is their liquidity, which is considered higher than that of mutual funds simply because they are more easily traded. So the money invested in ETFs do not stay locked to the fund and can be readily traded during market hours.

Purchasing shares of a single company can limit the diversity of an investor’s portfolio. ETFs make it possible to invest in a range of stocks comprised in the fund. So, in a lot of ways, ETFs are seen as a win-win investment, bringing in the liquidity of a share or bond and the diversification benefits of a fund.

 

How did ETFs Gain Prominence in India?

In 2001, the first ETF, NiftyBeES was launched. The following years saw a surge in Gold ETFs, which are funds tied to the price of gold bullion.

The fund flow of ETFs was fairly low until regulations supporting the ETF industry were implemented. In 2013, a budget reform to promote ETFs at par with mutual funds attracted investors’ interest. When the Indian government began divesting its public sector units (PSUs) to fund companies, the government’s equity holding in these PSUs became open to public investors. This further attracted buyers.

Policy reforms encouraging ETF investment in India as recent as December 2019, allow investors to buy government debt through corporate bond ETFs known as Bharat Bond ETFs.

These initiatives have brought awareness to ETFs as a viable investment product. By end of August 2020, ETF asset under management (ETF AUM) in India stood at Rs. 2.07 lakh crore ($2.07tn), with almost half of this amount parked in Nifty50-based ETFs.

 

Investment in ETFs

 

What Kind of ETFs are Common in India?

The most common form of ETFs traded in India are equity-based, which reflect the composition of a particular stock index like Nifty 50 and S&P BSE Sensex. Gold ETFs are also a common form of investment given Indians’ penchant for gold. Such commodity ETFs are linked to the price of that asset.

Other types of ETFs include debt ETFs, which are offered on debentures and government bonds, and currency ETFs, which are pegged to various currencies in the world.

 

Are There Any Obstacles to the ETFs Industry in India?

Liquidity is often cited as an advantage of ETFs. In India, however, this feature hits a modest rate at best. Close to 90% of ETFs in India are owned primarily by the Employee Provident Fund Organisation (EPFO). Compared to mature ETF markets like the US, where the ETF flow comes from advisors as well as institutions, India’s one-way flow from the institutional side alone could limit its liquidity.

Each fund in India needs to have a minimum of 10 stocks for Equity ETFs or 8 issues for Debt ETFs. These thresholds for ETFs, as established by SEBI, have led to a few funds being concentrated with a few prominent stocks, leaving little room for others to be added to the mix.

Concerns over the representation of mainly large-cap indices in ETFs has been growing. Midcaps and small caps, which offer high returns in the long run, are not mirrored in the composition of ETFs as much as their larger counterparts.

It’s safe to say that ETFs can be a basket of surprises. But with potential to be present across stock types and securities and renewed government support, ETFs may be the right balance of flexibility and diversity that investors are looking for.

FIN.

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