Clients, Planners And ETFs

Exchange Traded Funds (ETFs) are one of the most popular passive investment products. They allow access to a variety of indices and asset classes. Financial planners everywhere are therefore beginning to recommend ETFs to their clients. There are cases where portfolios are designed entirely with ETFs.

There are ETFs that track a broad market index, a particular sector, an investment theme or a particular factor. Therefore investing in ETFs requires us to solve for a complex problem of plenty.

So the choices that investors make within the ETF space would impact how well they do. They must therefore fully understand the principles that govern ETF investing. And this is where professional advice can be of great help. And today I will show how advisors can educate clients on ETFs. This would enable clients to make better choices within the ETF space.

Relevance To Requirements

ETFs are ideally suited to investors who follow a simple, low cost and diversified approach to portfolio construction. Care should be taken to ensure that such investors actually understand what to expect from ETFs. Their expectations must be aligned to the kind of investment experience that is offered by an ETF. Investors who prefer a concentrated or active approach to portfolio construction may avoid ETFs altogether.

Aligning Choices To Risk Profiles

It is a misconception to think that all ETFs are low risk products. Broad market ETFs carry the lowest degree of risk within the ETF space. Sectoral, thematic and factor based ETFs carry a relatively higher degree of risk. Some clients may simply need a single broad market ETF. Others may require a combination of various categories of ETFs. Planners must therefore align ETF choices to the client’s risk profile.

Costs, Liquidity And Tax Efficiency

Most Indian ETFs that are worth investing in currently carry an annual total expense ratio of 0.05% to 0.06%. The best way to guage the liquidity of an ETF is to look at its daily trading volume. This is represented by the number of units of an ETF that are traded everyday. ETFs worth investing in consistently have average daily trading volumes must be reasonable of at least a lakh every day.

Finally, it is important to consider that there are some ETFs that pay dividends. Dividends are invariably taxable in the hands of the ETF holder. Such ETFs may not be a tax efficient choice for the client. Planners must therefore ensure that they do not suggest them to clients who fall under the tax net. Most Indian ETFs do not pay a dividend. So there is no major concern for Indian investors on this particular front. But they would still need to ensure that their choices are sound with regard to costs and liquidity.

Factor ETFs

Factor ETFs are one of the newest offerings in the ETF space. They are also called Smart Beta ETFs. 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. The stocks are picked based on certain preset rules, criteria or factors which are called Betas. Therefore these ETFs look to combine active management and passive investing. This provides investors with the best of both worlds. Planners must therefore not recommend them to clients looking for a purely passive portfolio.

Each factor is meant to achieve a specific objective. Planners need to educate their clients on the underlying factors inherent to a particular factor ETF. 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.

Final Thoughts

The ETF space in India currently has significant scope for evolution. But new, well managed ETF products would continue to enter and evolve in India over the coming years. ETFs may then represent a much more holistic solution to the needs of most clients. This could make them a popular tool for planners to use. ETF investing is therefore highly likely to play a major role in the way financial advise is imparted in India over the years to come. The planner's role would gain significance in terms of research, judgement of client risk profiles and educating clients on ETF investing. Advisors must therefore play each of these roles effectively to keep abreast of emerging advisory needs.