ETFs are experiencing a surge in popularity, with total assets in India reaching approximately Rs. 6.5 lakh crores. However, it's crucial to be mindful of the impact cost, as lower liquidity in a specific ETF can lead to higher costs. For instance, within the same ETF category, such as Nifty, impact costs can vary significantly, ranging from as low as 0.02% to as high as 2%.
Investors are advised to carefully assess volume and impact cost data before making investment decisions. In an interview with Navneet Dubey of BT Money Today, Arun Sundaresan, Head ETF at Nippon Life India Asset Management Ltd.
(NAM India), discusses the potential risks for individual ETF investors. Sundaresan delves into whether ETFs can function as shock absorbers due to their liquidity or, conversely, contribute to increased volatility.Edited Excerpts:
BT: What are ETFs, and how do they differ from mutual funds? And how can you place ETFs in your portfolio in current market situations?
AS: Exchange Traded Funds, or ETFs as they are called, are also mutual funds. The key difference is that ETFs are listed on the stock exchanges just like stocks or debt securities. ETFs replicate a particular index. For example, a Nifty ETF will have the same stocks and in the same proportion as the Nifty 50 index. Investors get to participate in the segment of markets as they choose.
Several types of ETFs allow investors to invest in equities, fixed income and commodities markets. Within each asset class, there are several funds to choose from. For instance, investors could invest in market cap-based funds like large cap, mid cap or small cap. They could also play sectors or themes like Banking, IT, Consumption, etc. through ETFs. Similarly, there are a host of fixed-income strategies and gold and silver ETFs that allow investors to make their asset allocations and have specific investment strategies. Therefore, regardless of market conditions and based on individual investment preferences, investors could choose and invest in a range of ETFs.
BT: What exactly is liquidity in the context of ETFs, and why is it so important for investors?
AS: Liquidity to ETFs is like water to fish; it’s critical that when investors attempt to buy an ETF on the exchange, there should be sellers, and vice versa. There should be sufficient trading volume in the particular ETF to ensure that the transaction happens at prices which are close to the price displayed on the exchanges. For example, think of a stock or an ETF, which is trading at a price of 100, and an investor is attempting to sell the same. When he places the sale order, it should ideally get executed at a price close to 100. Now, this would happen only if there were sufficient volume, and the stock or ETF is liquid. Else, there would be a high Impact Cost (IC), and the sale price may be, say, 97 or 98 instead of 100, in which case, the investor loses 2-3% returns due to lack of liquidity in this case. Liquidity, which is essentially good trading volume, is very important in the context of ETFs and would have a direct bearing on returns.
BT: Can you explain the difference between primary and secondary market liquidity for ETFs and how each plays a role?
AS: The trading volume that happens in the exchanges is secondary market liquidity. Good trading volume is essential for ensuring efficient transactions of ETFs on the stock exchanges. For large transactions, which are above Rs 25 crores, investors can transact directly with the Asset Management Companies.
BT: What are some key metrics investors can use to gauge the liquidity of an ETF before investing? Have you observed any recent trends in ETF liquidity, and what might be driving them?
AS: Volume of transactions and Impact Cost (IC) are two important metrics that investors have to assess before choosing to invest into ETFs. This data is available on the stock exchanges. Investors will just have to type out the name of the ETF, and they could find a lot of data about the ETF. The trading volume for any period in consideration, and the impact cost of the ETF are published. Higher trading volume and lower impact cost should be preferred.
Generally, when overall market sentiments are good, activity levels tend to go up, resulting in better volumes. However, the volumes tend to differ between different types of ETFs and within the same category between ETFs. Hence, investors need to assess the same before making any investment decisions.
BT: Do you think ETFs enhance access to diverse asset classes for retail investors due to their liquidity? In times of market volatility, can ETFs act as shock absorbers due to their liquidity, or can they exacerbate volatility?
AS: ETFs certainly offer investors the opportunity to invest across diverse asset classes. Equity, fixed income, gold, and silver are the various asset classes that investors could take exposure to using ETFs. There are various strategies within these asset classes. For instance, there are ETFs which allow investors to invest only into Government Securities and there are also ETFs which provide exposure to corporate bonds. On the equity side, there are several innovative strategy ETFs like Dividend Yield, Value, etc., through which specific strategies could be played out. Volatility in the market would impact ETFs as well, though if investors ride that out well by matching their investment strategies with their objectives, they could have a pleasant experience in the long term.
BT: Are there specific types of ETFs (e.g., smart beta, thematic) that tend to be more or less liquid?
AS: Within the ETFs, the market cap-based ETFs like Nifty, Midcap, etc tend to be relatively more popular and, hence, command higher volumes. Other types of ETFs, which are based on specific strategies, could be relatively less on liquidity. Hence, investors should build and reduce their exposures in these funds gradually.
BT: How do you see the liquidity landscape for ETFs evolving in India over the next few years?
AS: ETFs are gaining popularity. Total assets in ETFs in India are approximately Rs 6.5 lakh crores. This accounts for roughly 13% of the total mutual fund assets. In the global scenario, ETF assets are over 10.5 trillion USD, and in many developed countries, ETF assets account for more than 50% of the mutual fund assets. We expect significant growth in the ETFs in India in the future, which will further enhance the liquidity landscape for ETFs
BT: How crucial is it for an investor to keep track of tracking errors?
AS: An ETF should very closely replicate the underlying index. For example, if an index has delivered 10% returns, the ETF return also should be similar. Tracking Error measures how close the ETF return is when compared to the index and how volatile this difference in returns is. A lower Tracking Error would mean that the ETF is replicating the index closely. It is an indication of how well the ETF is managed and is one of the important considerations for investors.
