How to pick the right equity ETF

Exchange traded funds were first introduced in India in 2001. Despite their low cost, simplicity and transparency, retail participation in ETFs has been low.

However, there has been increased interest among retail investors in recent times, thanks to the underperformance of the actively-managed large-cap equity funds against their respective benchmarks such as the Nifty 50 TRI and the Sensex 30 TRI.

Data sourced from the AMFI shows that the retail AUM in the ‘other ETFs’ category (which includes all ETFs, excluding gold) grew significantly by 120 per cent in FY19 to ₹6,534 crore. In FY18, the retail AUM in the ‘other ETFs’ category grew by only 10 per cent.

ETFs, like equity shares, are passively-managed mutual funds traded on the BSE and the NSE. An ETF simply copies an index and endeavours to accurately reflect its performance. Through demat accounts, investors can buy and sell ETF units at the prevailing market prices during market hours.

The other popular variant for passive investing is index fund, which is like any normal mutual fund scheme. Unlike ETFs, index funds are not traded in the exchanges. Their NAVs are declared at the end of the trading day. Investors can buy and sell the units of the index funds at the NAV price from the mutual funds.

Lower expense ratio, transparency and nil fund manager risk are advantages in ETF investing. However, low liquidity, mandatory demat and trading account and broker commission and transaction charges are the negatives. The choice of ETFs has increased in India over the last few years. Currently, they are available across asset classes, including equity, debt and gold.

We take a closer look at equity ETF categories and the factors to be considered while investing in them.

Equity ETFs

There are 61 ETFs tracking equity indices. We have a wide choice of ETFs based on the broader equity indices, including the Sensex, the Nifty 50, the Nifty Next 50, the Sensex Next 50, the Nifty 100, the Nifty Midcap and the BSE 500. Sector, thematic, and smart beta ETFs are also part of the offerings.

ETFs are suitable for those new to equity investing. Investors looking at market-linked returns and not wanting fund manager’s involvement can consider the ETF route.

ETFs can be part of one’s portfolio and used for an effective asset allocation strategy. Since they are traded on exchanges, ETFs can be used as collaterals for margin purchases or for parking your liquid money for shorter periods.

Factors to consider

Asset size, liquidity, tracking error (TE), expense ratio, impact cost and premium or discount of the spot price to its NAV determine the suitability of the ETF to your portfolio.

Large asset size preferable: Normally, large asset size (or corpus) in an ETF implies the likelihood of more active trading in the exchanges. Ideally, ETFs with corpus of at least ₹100 crore are preferable. Of the 61 equity ETFs, 23 have corpus over ₹100 crore.

Some equity ETFs are large in size due to heavy investment by the EPFO. These include SBI ETF Nifty 50, SBI ETF SENSEX, UTI-Nifty ETF, CPSE ETF and Bharat 22 ETF. Reliance ETF Bank BeES, Reliance ETF Nifty BeES, Kotak Banking ETF, ICICI Pru Nifty ETF, Kotak Nifty ETF, LIC MF ETF Nifty, LIC MF ETF Sensex, LIC MF ETF Nifty 100 and HDFC Nifty 50 ETF also have larger corpus.

Volume decides liquidity: Liquidity or the trading volume plays an important part in ETF selection. Since you can sell units only on the stock exchange, it is imperative that there are buyers and you are able to get a good price.

Illiquidity is the most important short-coming in ETFs. In India, most ETFs are thinly traded. The average daily total volume traded in the equity ETFs on the NSE over the last year was only ₹88 crore, while on the BSE, it was a meagre ₹7 crore.

However, liquidity is not a concern for large investors who can directly approach the AMCs for purchase and redemption of ETF units if the transaction size is big, amounting to at least one lot. The lot size is determined by the fund house. One lot size in Reliance ETF Nifty BeES is 5,000 units (approximately ₹58 lakh).

If you have decided to buy ETFs, choose those that are traded every day, with decent volumes. You should strictly avoid thinly-traded ETFs. You can get to know the daily traded volume in the ETFs by looking at the BSE and NSE websites.

Of the 61 equity ETFs, only nine had an average daily traded volume of more than ₹1 crore in the past year. CPSE ETF, Bharat 22 ETF, Reliance ETF Bank BeES, Reliance ETF Nifty BeES and Kotak Banking ETF are the top five actively traded equity ETFs in India with daily average volumes of ₹38 crore, ₹17 crore, ₹11 crore, ₹6 crore and ₹5 crore respectively.

However, 28 equity ETFs were traded on every working day (243 days) over the last year.

Lower impact cost: The impact cost in an ETF would be lower if there is higher liquidity in the exchange. The impact cost is nothing but an indirect transaction cost incurred due to higher bid-ask spread.

When executing buy orders, you may not get the desired price due to lack of sellers at the terminal, which may result in you paying a higher buying price than the desired price. This will increase your purchase cost.

Impact cost data is available on the BSE and the NSE websites. The mean impact cost in July for the Sensex 30 stocks ranged from 0.01-0.03 per cent. For the BSE 100 Index stocks, the mean impact cost was in the 0.01-0.09 per cent range, while for the BSE Midcap 100 stocks, it was between 0.03 and 0.74 per cent. Given these factors, ETFs with mean impact cost of up to 0.10 per cent are preferred.

ETFs with low impact cost are Reliance ETF Nifty BeES (0.06 per cent), CPSE ETF (0.07 per cent), Bharat 22 ETF (0.08 per cent), Reliance ETF Junior BeES (0.11 per cent) and ICICI Pru Nifty ETF (0.12 per cent). The impact cost of the ETFs differ every month based on the liquidity condition in the market.

Tracking error (TE): Apart from the returns, the efficacy of ETFs is measured through the TE, which shows how closely an ETF tracks its chosen index. In simple terms, TE is the difference in returns between an ETF and its benchmark. ETFs with lower TE are preferred. TE may arise mainly due to the cash holding and lag time to rebalance the constituents in line with the index.

TE calculated from the last one year NAV history shows 42 out of the 61 equity ETFs tracked their respective indices closely. Their TEs were in the 0.01-0.05 per cent range. HDFC Sensex ETF, Kotak Banking ETF, SBI BSE 100 ETF, UTI-Nifty ETF, SBI ETF Nifty 50 and Reliance ETF Bank BeES have shown lower TEs over the past year.

Expense ratio: ETFs are cost-effective as they charge relatively lower expense ratio compared to the regular and direct plans of the actively-managed equity funds and index funds.

For instance, the average expense ratio charged by the ETFs tracking the Nifty 50 as benchmark, as of June 2019, was only 0.08 per cent, while the regular and direct plans of the active large-cap equity funds were 2.3 and 1.3 per cent respectively. The regular and direct plans of the index funds were 0.7 and 0.3 per cent respectively.

Premiums and discounts: During the trading hours, the spot price of the ETFs may trade at a premium or discount to their iNAVs (indicative NAVs). This occurs due to illiquidity and less-active market makers. Market makers are authorised participants appointed by the AMCs to keep the spot price close to the fair value.

iNAV provides an intraday indicative value of an ETF based on the market values of its underlying constituents. The value is calculated by the exchange and then disseminated to the public every 15 seconds. They are displayed in the mutual funds’ websites on a real-time basis. AMCs, including Reliance mutual fund, show iNAVs in their websites.

If the price of the ETF trades above its iNAV, the ETF is said to be trading at a ‘premium’ and if the price is below its iNAV, it is said to be trading at a ‘discount.’ This leads to higher impact cost. An ETF with the market price having smaller premiums and discounts to its iNAV is preferable.

Historical data calculated from the close price and NAV of the ETF will give you an idea about the past trend. The premium or discount data compiled over the last year shows that the market prices of ETFs, including Reliance Nifty BeES, ICICI Pru Bank ETF, SBI ETF Quality, ICICI Pru Nifty ETF, Reliance ETF Bank BeES and Reliance ETF Junior BeES, have smaller premiums and discounts to their respective NAVs.

The equity ETFs are sub-classified based on the index they track.

Broader index ETFs

The ETFs under this basket track the broader and well-known indices such as the Sensex and the Nifty 50. They include large actively-traded stocks from diversified and leading industries. These indices reflect the broader economy. Any investor who wants to participate in India’s growth story can consider investing in these ETFs. There are 17 Nifty 50 ETFs and nine Sensex ETFs available currently.

Of these, only four Nifty 50 ETFs have matched our above-mentioned screening parameters such as higher liquidity, low impact cost and TE.

They are Reliance ETF Nifty BeES, ICICI Pru Nifty ETF, SBI ETF Nifty 50 and Kotak Nifty ETF. Though few Sensex ETFs score over many parameters, their low liquidity has been the deterrent.

Apart from these, there are five Nifty Next 50 ETFs, three Sensex Next 50 ETFs, three Nifty 100 ETFs, one BSE 100 ETF, three Midcap ETFs and one BSE 500 ETFs available in the market.

Reliance ETF Junior BeES and Reliance ETF Nifty Midcap 150 (recently launched) score on all counts.

ICICI Pru S&P BSE 500 ETF, launched a year back, is a far more diversified index representative of the whole market. However, the investors’ interest is limited (with corpus of only ₹18 crore) and the liquidity is also very low.

Our take: One should avoid ETFs with low liquidity. Investors worried about the liquidity can consider index funds, which enable SIP purchasing.

The recently-launched fund of fund schemes — ICICI Pru Bharat 22 FoF and Reliance Junior BeES FoF, which invest in the respective ETFs — also allow the SIP route. These FoFs qualify as equity funds for tax purposes.

Sector and thematic ETFs

Of the 13 sector ETFs, five track the Nifty Bank Index, two follow the PSU Bank Index and two track the indices of public sector stocks. We have dedicated thematic ETFs for consumption, Shariah, infrastructure and dividend opportunities, but they are traded thinly.

Our take: Sector and thematic ETFs are suitable for investors with very high risk profile, who understand the market cycle and sector trends. Of the ETFs tracking bank index, Reliance ETF Bank BeES and SBI ETF Nifty Bank trade with higher liquidity and low TE.

CPSE ETF and Bharat 22 ETF, which were launched to execute the government’s divestment programme, trade with higher volume on the NSE. However, their performance has not been up to the mark since their launch.

Smart Beta ETFs

Smart Beta ETFs or strategic ETFs, which are straddling the line between active and passive strategy, are gaining popularity around the world. They attempt to beat the traditional market-capitalisation-weighted index by altering the level of risk relative to a standard benchmark.

These new age ETFs track custom-made indices such as the Nifty 50 Value 20 Index and the Nifty 100 Low Volatility 30 Index.

These indices use a variety of fundamental, technical or other filters to choose their constituents. For instance, the Nifty’s low volatility index looks for companies with historically low volatility (standard deviation) in price.

Our take: Currently, there are six ETFs available in the space. They have put up a mixed show since their launch. All the six ETFs trade with thin volumes in the exchanges.

The success of a smart beta ETFs will be based on how the underlying index is constructed to capture the future trend correctly. Investors can wait and watch till the ETFs prove their mettle and the liquidity improves.

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