Why is Exchange traded funds the new buzz word and the relevance in a portfolio?

By Koel Ghosh, ETF Junction

Wednesday, September 6, 2023

There is always an ongoing debate on whether fund manager-based portfolios are better or index-based investing. The two styles are popularly called active and passive respectively. Active investing can be direct investing in securities or via mutual funds and passive investing via index funds and ETFs.

Exchange Traded Funds or ETFs have witnessed an exponential growth in India. In the last 5 years passive grew at a compounded annual growth rate of 30%* with assets under management growing from INR 1.47 lakh crores to INR 5.48lakh crores. The number of products or ETF growing from a mere 79 to 174. The year-on-year ETF growth was the highest in the last 5 years at 77% with a growth in assets of over INR 1.39 lakh crores.

No wonder interest in ETFs is growing by leaps and bounds. It is a low cost, transparent, diversified, flexible and comparable liquid option in investing. They replicate the underlying index which aims to provide a similar investment experience as the index. For eg, if the ETF tracks the Nifty or Sensex, its fund characteristics and risk return profile are similar to the index. The differentiation in returns can be on account of tracking error which is a difference in the returns of the index and ETF owing to cash balances held, expenses, etc. The tracking errors are shared by ETF providers that allows investors to evaluate the performance of the ETF and its variance from the underlying index.

In a portfolio the investment goal or objective determines selection of style or strategy. In India there is a bias to active investment but scorecards such as SPIVA are demystifying the advantage of passive investment. In their report over the last decade, large cap funds have been largely and consistently underperforming the benchmark. To explain that, if you were investing in the benchmark index, there would be over a 50% chance in most of the years as shown below that the index had outperformed the active funds. The trend is across 1year, 3year, 5 years and 10 years.

This provides a clear understanding as to why they need a place in a portfolio. The above trend is demonstrative of a large cap index is outperforming active funds. There are many diverse themes, sectors, segments, geographical boundaries that can be accessed via ETFs which replicate the underlying index. Hence to avail of its passive nature of investing, there are portfolios who are now adopting this avenue along with other existing strategies.

AMFIdata comparing June 30,199 and June 30, 2023
AMFI data – comparing 5 years from June 30,1999 to June 30, 2023

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