How to pick a passively managed fund

Exchange-traded funds and index funds both mirror indices. But there are differences in structures and costs

Till only a few years back, the choice was easy. You don’t like an actively-managed fund? You want to avoid fund manager’s risk? Pick an index fund or an exchange-traded fund (ETF). There were just a handful of them. By the end of 2005, there were just 16 of them as opposed to 118 actively-managed diversified equity-oriented funds. But between then and the end of 2010, another 18 passive funds were launched. And between 2011 and now, 32 more were launched, taking the total number of equity-oriented ETFs and index funds to 66. And these are just equity-oriented ones; we did not count the 13 gold ETFs that are there. So, should you buy an index fund or an ETF? Mint Money takes you through the steps.

What are passive funds?

For the purpose of this story, let’s stick to only equity-oriented passive funds. But there’s still a minor difference between an index fund and an ETF. An index fund invests its entire corpus in all the scrips, and in almost the same proportion as they lie in the benchmark index (with some cash to meet redemption requirements). An ETF does the same, but its mechanism is different. In ETFs, units are created and dissolved and this only happens in a predefined lot, commonly known as ‘creation unit’. A creation unit size translates into the complete basket of stocks forming the benchmark index in exactly the same proportion. Fund houses (ETF managers) create and dissolve units. They appoint market makers who are given the task of ensuring liquidity of the units and making them available on the stock exchanges. Alternatively, large investors can directly deal with the fund houses, but if you wish to go to the fund house, the unit size requirement is usually large.

These market makers can give the basket of stocks that form the creation unit (or give the cash equivalent to the creation unit size) to the fund house in exchange of an ETF unit. The market makers then make these units available on the stock exchange where investors can buy. Similarly, market makers buy the units on the exchange and surrender them to the fund house, if they wish to get back the underlying basket of shares.

Not many financial planners recommend ETFs and passive funds as they feel they can do a better job of managing their client’s portfolios by suggesting active funds. But distributors like Mukesh Dedhia say sometimes passive funds help. “When markets are at a low, it is possible that we don’t know which sectors will do well once the markets start looking up. But what we do know is that the index (a broad market index) will do well. So, an index fund or an ETF would bode well,” said Dedhia.

Superior structure...

Mint Money has always recommended an ETF as your first choice in passive funds. An ETF’s structure is such that you get your units at a value that is closest to its underlying value, which is the value of the underlying benchmark index. This is subject to a few conditions, which we’ll talk about later, but in an efficient market, here’s how it works. If the scheme is cheaper than the index, market makers will buy the scheme from the market and exchange it with the fund house for the actual basket of shares. On the other hand, if the index is cheaper than the scheme, the market maker will get the units from the fund house and sell them in the market. Such demand and supply created due to an ETF’s structure results in the price of the index and scheme staying close to each other. In other words, you pay for what you get.

A lower expense ratio is also where typically an ETF scores over an index fund. Lower the expense ratio, the better it is for a passive fund. Given that passive funds aim to mirror market returns, a higher expense ratio tends to eat into their returns. Although equity funds can charge up to 2.5% (plus another 50 basis points are allowed to aid penetration, as of now), index funds and ETFs charge lower fees because there’s hardly any fund management involved. A basis point is one-hundredth of a percentage point.

An ETF’s expense ratio is much lower than an index fund’s because of less number of transactions in the scheme. Since one unit of ETF is always constant (number and the quantity of stocks is fixed), every transaction adds or reduces one lot of the benchmark index in the overall pool. In the case of index funds, every time the fund gets inflow, it needs to be invested in the pool of securities at the same moment and it has to be ensured that the total pool is as close to the benchmark index proportion as possible.

Expense ratios have further come down because institutional investors are now showing interest in them. In March 2014, the Insurance Regulatory and Development Authority of India allowed insurance companies to invest in ETFs launched by MFs, subject to a few conditions. In 2015, the labour ministry decided to invest 5-15% of Employees’ Provident Fund Organisation’s (EPFO) incremental corpus in ETFs. Eventually, it shortlisted two ETFs, SBI-ETF Nifty (SEN) and SBI Sensex ETF (SSE), and decided to invest 5% of its incremental corpus (a little over `7,000 crore) in them.

A total of 11 ETFs have their expense ratios up to or less than 10 basis points.

Index funds, too, have lowered their expense ratios. UTI Nifty Fund (UNF), IDFC Nifty Fund and HDFC Index Fund-Sensex Plan have the lowest expense ratios among all index funds at 21, 27 and 30 basis points, respectively, as per April-end portfolios and as per data by Value Research.

An eye on tracking error

Tracking error is a measure of the deviation between the returns of the fund and its benchmark. It’s not an absolute difference, but it is a simple formula. The higher the tracking error, the higher is the deviation of the fund from its benchmark. As index funds and ETFs aim to mirror market returns, the lower the tracking error, the better is your fund. In the initial years, ETFs had far lower tracking errors than index funds. But over time index funds have been able to lower their tracking errors.

...but watch out for liquidity

ETFs may, typically, have lower expense ratios and tracking errors than index funds, but keep an eye on their impact cost. Expressed in percentage terms, an ETF’s impact cost is the difference between the scheme’s net asset value (NAV) and the actual market price at which you get to buy your units. Say, your ETF’s NAV is `83.27 and you want to buy 1,000 units. You’d think that you would need to pay `83,270. In reality, you won’t get all the units at that price. Some units will be available at a certain price that’s the closest to your NAV. Maybe only 56 units are available at `83.45. If you want to buy more units, you will have to pay more. Let’s say another 58 units are available at `83.65. And another batch of, say, 58 units are available; now at a price of `83.85. And so on. Notice how the price keeps inching up as you keep buying units. This is called the impact cost and is determined by liquidity.

“It’s a myth that just because an ETF shows large trading volumes—a figure that is publicly available on exchange platforms—it is liquid. Look at the impact cost. If more and more units are available at the desired price, it means that the fund is truly liquid. So, keeping the ‘impact’ low is essential,” said Manas Shukla, head-ETFs, Edelweiss Asset Management Ltd.

Deciphering this on your own is not possible because impact cost details are not readily available. So, if you decide to buy a passive fund, start with an ETF but do keep an index fund as a back-up. Then check with your broker if units are readily available at the price that is closest to your NAV. If she says yes, go ahead and buy your chosen ETF. Else, settle for an index fund. Since the expense ratio of an index fund’s direct plan is much lower, you will save there as well.

There’s another angle that might mislead you into thinking one ETF is cheaper than the other. In an ETF, one unit is priced at a fraction of the underlying Nifty value, say, 1/10th or 1/100th. Its NAV on any given day will typically be lower than those whose single ETF units are priced at the same value as the underlying indices. “It’s the same `10-NAV-is-cheaper-than-`100 myth that was once popular; that the lower the NAV, the better is the fund. A lower ETF can sometimes be perceived to be a better scheme, which is not the case,” said Shukla.

Booming variety

Typically, index funds—and even ETFs to begin with—benchmarked themselves only to Sensex and Nifty; two main broad-based indices in India. But due to an ETF’s structure, fund houses started warming to other indices as well. From launching small- and mid-cap indices to foreign indices’ ETFs, fund houses got imaginative. In 2010, Goldman Sachs Asset Management (India) Pvt. Ltd launched an ETF based on Hong Kong’s Hang Seng index. In 2011, Motilal Oswal Asset Management Co. Ltd launched an ETF based on the Nasdaq. “We launched Nasdaq100 fund for two reasons. One was to provide potential for capital appreciation to investors from prospects of cutting edge new businesses that form part of the Nasdaq100 index. Indian investors had no other way to participate in this opportunity. Second was to provide an opportunity to hold dollar assets so as to diversify risk and enable long range planning, because for a lot of us, our earnings are in rupees but some of our goals and hence future liabilities are willy-nilly linked to the dollar,” said Aashish P. Somaiyaa, managing director and chief executive officer, Motilal Oswal Asset Management.

Fund houses also started to launch sector and thematic indices. Banking sector was a favourite; there are four bank index-based ETFs as of today.

That’s not all. Fund houses started to improvise. In 2010, Motilal Oswal Asset Management launched its own version of an so-called actively-managed ETF. It re-jigged the Nifty50 index and rearranged the stocks based on a model it had developed. The stocks were the same as in the Nifty50 but their order was changed. Did it work? Between the calendar years of 2011 and 2014, M50 outperformed Nifty50 in two years. But the corpus didn’t go anywhere much and so they changed track. In October 2014, the fund house changed the attribute of M50 and converted it to a plain-vanilla ETF that tracks the Nifty50 the way the index is there. “It was a smart beta strategy. But ETFs in our country haven’t taken off. There were costs in running a smart beta strategy but we realised that awareness was low; explaining the concept and communicating its benefits was tough. Hence, we changed it into a plain-vanilla ETF,” said Somaiyaa.

But taking this a step further is Edelweiss Asset Management’s latest launch, Edelweiss ETF-Nifty Quality 30 (E30). Its benchmark is Nifty Quality 30 index. This index consists of 30 stocks and it curates stocks out of the top 100 stocks by market capitalisation on the basis of return-on-equity (the higher the better), debt-equity ratio (the lower the better), and profitability track record. The National Stock Exchange manages this index, so other fund houses can also launch ETFs benchmarked to it. But for now, E30 is the only one.

Mint Money take

ETFs are a good product if you wish to avoid fund manager’s risk. But most of them suffer from lack of liquidity. Even if units are available for many of them, if the impact cost goes up, you might end up compromising on cost. Keep an index fund as back-up. If you take the direct plan route, you’ll save on costs. 24-06-2016