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Last Updated : Oct 31, 2019 06:27 PM IST | Source: Moneycontrol.com

Why retail interest is less in ETFs and more in index funds

Index mutual funds allow shareholders to reinvest their dividends automatically, commission-free. ETFs don't usually offer that service, and if they do, they are less efficient.

At a time when active fund managers are unable to beat the benchmark due to extreme volatility in the markets, mutual fund experts recommend investing in ETFs or index funds.

But experts said among ETFs and index funds, retail investors prefer to deploy their cash in index funds over ETFs.

Exchange-traded funds, simply told, offer a low-cost, transparent, convenient and equitable way of indexing.

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Indexing is the process of linking the performance of a portfolio of stock to that of an index. More specifically, it involves investing in a pool of stocks that form part of an index in the same proportion as is there in the index.

With indexing, one can look forward confidently to beating the most active funds.

Alternatively, indexing allows the investor to quantitatively track and measure the returns that have been earned by some underlying group of securities.

It is convenient as it becomes a 'Set it-forget it' strategy as the returns will not stray far from that of the market.

ETFs vs Index funds

ETFs can be more tax-efficient than index mutual funds. Index mutual funds don't require investors to pay a commission to a brokerage company, but ETFs do.

Index mutual funds allow shareholders to reinvest their dividends automatically, commission-free. ETFs don't usually offer that service, and if they do, they are less efficient.

The ETF being listed presents its own opportunities and disadvantages.

Being listed, ETFs can be bought and sold with both on the stock exchange or the issuing mutual fund.

On listed exchange, trading like a stock, it can help an investor get aggressive returns like a stock on a rising day, through buy low now, sell when high strategies.

Index funds can only be purchased and sold with the issuing mutual fund at day-end NAV, therefore intra-day index volatility movements cannot be profited from.

In ETF behaving like a stock, lies the disadvantage as well vis-a-vis the index funds. There are brokerage costs, custodian costs involved over and above the regular mutual fund transaction costs.

Indexing To Beat Active Investing

According to passive fund experts, active fund managers that beat indices demonstrate no consistency and hence should not be looked as champions but merely as lottery winners.

As investment guru Peter Lynch has said, "All the time and effort people devote to picking the right fund, the hot hand, the great manager has, in most cases, led to no advantage and most individual investors would be better off in an index mutual fund."

Slow ETF growth in India

"Today due to the lack of trading activity, a retail investor who is paying 0.15 percent expense ratio has charges of 0.2 percent brokerage/STT (securities transaction tax) and another 0.3-0.4 percent liquidity related costs – resulting in up to 1 percent of the premium when he’s buying and the same at discount when he is selling," said According to Prateek Oswal, Head-Passive Funds, Motilal Oswal Asset Management Company.

It is noteworthy that for exchange trading liquidity in ETFs, there is a provision of market maker in ETFs in all mutual fund schemes, an entity that gives buy and sell quotes for the listed ETF mutual fund units.

A market maker sometimes called a designated broker (DB), who is a broker, dealer or investment firm that plays an essential role in how an ETF trades and ensures the continued and efficient exchange of securities between buyers and sellers

Earlier days till around 2008, ETF mutual funds voluntarily kept one market maker. Observing growing ETF interest and need for investor exit option on an exchange, SEBI made it compulsory since 2010 for a minimum of two active market makers for every ETF scheme, said a former SEBI DGM who worked in SEBI MF department on numerous Indian and abroad investing ETF schemes during that period.

Outside the exchange, when an ETF can be transacted with issuing mutual fund it is only an entire basket of a complete Nifty or a complete Sensex, making the minimum investment size very large running in multiple lakhs, a turn off for the retail investor.

"The flip side is provisioning more market makers only facilitates ETF buy-sell quotes on the exchange but is not a guarantee for trading liquidity because the market maker needs a buy-sell ETF spread as an incentive, to give continuous quotes, which is hard to find in Indian markets so far," opined the ex-SEBI officer.

Index Funds-Future of Passive Strategies in India?

Looking at lack of depth in the market for ETF mutual funds, the opportunity to play for following low-cost passive investment strategy are the index funds.

"There are various intermediaries such as the market-maker, exchange, broker and AMC that the customer has to coordinate with to buy an ETF today. Index funds help bypass all of them", quipped Oswal.

The theme of investing in index fund passives in overall asset allocation for the long term has an appealing potential for retail Indian investor as it does not have an ETFs' brokerage plus other exchange costs, still gives the passive low-cost investment advantages.

It seems that retail investors should look at passive index funds as a regular option for long-term asset allocation.

Within the world of passive investing, Index funds in India appear simpler and better accessible than ETF options.

"It is a much simpler buying experience than an ETF. Number two, because you can set up SIP, you don’t have to go through an exchange, broker or a market maker. Overall they are cheaper and don’t require demat accounts.  ETFs not entirely understood by retail investors" opined Oswal.

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First Published on Oct 31, 2019 06:20 pm
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