Exchange Traded Fund: Are ETFs ideal for Indian investors?

When you have Shikhar Dhawan explaining ETFs on national TV in an overtly expensive IPL ad spot, you know that they have truly arrived in India. There are 90+ ETFs managing over INR 2 trillion (~$27 billion) across asset classes. However, this is still a trickle compared to the US, where there are 2,000+ ETFs managing over $4 trillion. So, it would be fair to say that we are still in the early days of ETF (Exchange Traded Fund) adoption in India.

ETFs as a concept originated only about 25 years ago, but they have quickly captured the fancy of both institutional and retail investors around the world. They were initially promoted as a low-cost, index-investing option vis-à-vis mutual funds. Index investing itself is an age-old concept, made popular in the 1970s by John Bogle, the founder of Vanguard Group which is one of the largest asset managers in the world with over $6 trillion in AUM (Assets Under Management). Today, just the top 3 ETFs that track the S&P 500 manage over $730 billion.

One of the key reasons ETFs have become so popular in the US is that hedge funds and active managers have generally underperformed the S&P 500, especially over the last market cycle of 5-10 years. It looks like the same story is playing out in India too. Performance data shows that the top five AMCs in India (that account over 50% of AUM in equities) have been unable to generate alpha over the index in the last 5 years. So, on the face of it seems like ETFs that simply track the index (“Passive ETFs”) are a better bet for investors. The main draw of Passive ETFs comes from economies of scale, whereby large ETF providers can offer index tracking funds at close to zero fees.

So, the natural equilibrium for the ETF industry is that a few ETFs will account for most of the AUM. In addition, the underlying stocks in an ETF need to be liquid to minimize tracking error (difference between ETF and index returns) and maximize sufficient entry/exit liquidity for investors. As a result, large cap ETFs that mainly track the Nifty 50 and Sensex (a basket of 30 stocks) account for over 80% of total AUM in India.

While ETFs do offer a cost-effective option and easy access to equity markets for investors, there are broadly two areas of concern:

1. Large passive ETFs in the US are often blamed for additional volatility and concentration risk, since they control a large part of the pie. They can drive sharp movements in the markets (as seen this year in March), much more frequently than before the dominance of ETFs. This could easily happen in India too, especially given the lack of market depth here.

2. In addition, since ETFs mimic the index weights for individual stocks, they work in the favor of maintaining the status quo. Hence, they could exacerbate the dominance of a handful of stocks. Already, just the top 30 stocks (~1.25% of the total number of listed companies on the NSE) by market capitalization contribute ~49% of the entire market. From an ETF investor’s point of view, this means lack of diversification in her portfolio with insufficient exposure to mid and small caps.

I believe the answer lies somewhere in between the two broad options available to investors today i.e., systemized passive investing (passive ETFs) and active investing (human expert driven MFs/PMSs etc.). The future is a new class of investing, Systemized Active, which is standardized; rules-based investing that offers robust returns and diversification without emotions-driven human biases.

Over time the SEC (SEBI-equivalent in the US) has modernized their regulation framework whereby they have made it easier to create ETFs, to drive innovation and competition amongst providers. As a result, the number of ETFs in the US today are comparable to the number of individual stocks! Although the top 30 ETFs control over 40% of the total AUM, there is a slew of thematic and “active” ETF products available to the US investor. For example, there are ETFs that focus on ESG (environmental, social and governance) factors, or on the EV/Lithium industry, or even one that focuses only on the pet care industry.

If SEBI takes a similar approach, I think ETFs have a very bright future in India. They will not only offer ample opportunity to diversify and easy access for investors, but also lead to more liquidity across the spectrum of large-, mid-, and small-cap companies. This will in turn drive the flywheel of capital investments/innovation, growth, and more democratic wealth generation that propels India’s economy.

(By Atanuu Agarrwal, Co-founder, Upside AI)