Within the universe of passive investment products, Exchange Traded Funds (ETFs) are one of the most popular options among investors everywhere, alongside index mutual funds. The fact that ETFs involve low costs and can be freely traded on recognised stock exchanges add to their popularity that much more. Also, ETFs allow access to a variety of indices and asset classes. Advisors all over the world are therefore beginning to recommend ETFs to their clients, with entire portfolios being designed exclusively with ETFs.
ETFs are therefore widely viewed as low risk vehicles for portfolio construction. But such a perspective on ETFs is highly one dimensional. Because these products are actually available in multiple variations that cover various points on both ends of the risk spectrum. One could simply choose to invest in an ETF that tracks a broad market index, a particular sector (known as sectoral ETFs), a particular investment theme (known as thematic ETFs) or in an ETF that is built to align to a factor such as value, quality, dividend or low volatility (known as factor ETFs). Therefore investing in ETFs requires us to solve for a complex problem of plenty.
So the choices that investors make within the ETF space and the approach they adopt to ETF investing would go a long way to defining the level of success they would enjoy when investing in ETFs. But investors can make the transition to ETF investing successfully only when they fully understand the principles and philosophies that govern investments in ETFs And this is where professional advice from competent advisors can be of great help. And the focus of my discussion today will be the areas where advisors can play a role in understanding, educating and enabling choices within the ETF space for clients.
The first thing that advisors must help clients do is to help them understand whether or not ETFs are the right fit for their investment preferences. ETFs are ideally suited to those investors who wish to follow a simple, low cost approach to portfolio construction and wish to enjoy adequate diversification in their portfolios. But in the case of investors who prefer concentrated exposure or wish to gain exposure only to certain parts of an index while giving other parts a miss, ETFs may not offer the ideal structure to enable a selective and concentrated approach to investing.
Such investors may be better off picking the stocks of their choice from within an index of their choice and holding on to them. Or they may have to explore the option of selecting a well managed active fund to satisfy their preferences. Therefore, even though ETFs are advertised to be a product which can cater to the preferences of all investors, they are clearly not meant for everyone. Care should therefore be taken to ensure that investors to whom ETFs are suggested actually understand what to expect from ETFs, and are looking for the kind of investment experience that is offered by an ETF.
Today there are more than 100 ETFs available in India across asset classes. Also, it is a misconception to think that all ETFs are low risk products. Risk profiles of ETFs may vary from low to very high risk. Broad market ETFs are low risk, sectoral ETFs are medium risk, thematic ETFs are high risk and factor ETFs are very high risk products. With such a wide variety of products with varying risk profiles available, advisors would play an important role in helping each client pick the right ETF for their financial plan. Some clients may simply need a single broad market ETF, where others may require a combination of various categories of ETFs.
Costs, liquidity and tax efficiency are the key considerations to be made when picking an ETF. Most Indian ETFs that are worth investing in currently carry an annual cost of 5 to 6 basis points (translating into an annual total expense ratio of 0.05% to 0.06%). Another important factor to consider is the degree of liquidity offered by a given ETF. And the best way to guage the liquidity of an ETF is to look at its daily trading volume (the number of units of an ETF that are traded everyday). For an ETF to be worth investing in, its average daily trading volume must be reasonable (say at least a few lakhs every day) and consistent
Finally, it is important to consider that there are some ETFs that pay dividends. Therefore advisors must ensure that they do not pick them for clients who fall under the highest tax bracket, since such ETFs would prove to be tax inefficient for such clients. Specifically in the Indian context, apart from maybe one or two ETFs most others do not pay a dividend. So there is no major concern for Indian investors on this particular front, and most ETFs would prove to be a tax efficient option for Indian investors. But they would still need to ensure that their choices are efficient with regard to costs and liquidity.
Smart Beta ETFs or factor ETFs are one of the newest offerings in the ETF space and are quickly gaining popularity among investors. The world's first smart beta ETF was launched in the year 2003. These ETFs look to produce stable, sustainable returns by investing in a set of stocks within a broader market index based on certain preset rules, criteria or factors which are called Betas. Therefore these ETFs look to combine active management and passive investing, thereby providing investors with the best of both worlds.
Advisors would have an important role to play when suggesting factor based ETF strategies to clients. Each factor is meant to achieve a specific objective. Advisors need to educate their clients on the factor or combination of factors based on which a particular factor ETF has been constructed. For instance, a value ETF invests in a set of stocks that currently trade at a significant discount to their intrinsic value. Investors in such ETFs would therefore benefit when the gap between the current value and intrinsic value of these stocks converges. Some of the other common factors based on which factor ETFs are constructed have been set out in the graphic that follows.
An important benefit provided by factor ETFs is that there are factor ETFs available for investors with any kind of risk profile. And it is upto the advisor to accurately gauge a particular client’s risk profile and recommend an appropriate factor ETF accordingly. Clients with a conservative risk profile may be recommended smart beta strategies such as Value, Dividend or Low Volatility. This is especially an advantage for conservative investors since it allows them significant access to equity, which otherwise may not have been advisable. On the other hand, those with a slightly more aggressive risk profile may be recommended a Momentum or Growth ETF. This allows such investors to adopt an aggressive approach with a passive product, eliminating the need for active management.
The ETF space in India is currently in the early stages of its evolution. But as new, well managed products such as sectoral ETFs, thematic ETFs and factor ETFs continue to evolve and gain popularity in India over the next decade, ETFs would represent a much more holistic solution to the needs of most clients, making them a popular tool for advisors to use. ETF investing is therefore highly likely to be a major part of the way financial and investment advisory is imparted in India over the years to come.
When recommending ETFs to clients, the advisor's role would gain significance in terms of research, judgement of client risk profiling and educating clients on the discipline of ETF investing as a whole. Advisors must therefore be able to play each of these roles effectively to ensure that their services keep abreast of emerging advisory needs. It is the only way their services would retain their relevance in the years and decades to come.