Nate Most, the head of product development at American Stock Exchange, who first proposed the ‘ETF idea’ would have never imagined that a couple of decades later ETFs would become one of the most disruptive force in the investment and asset management industry. The ETF advantage can be judged by the fact that these are essentially low-cost passive index funds that can be traded like stocks on the capital market segment.
In India currently, ETF AUM is over Rs 4 lah crore and growing at a rapid pace. The ETF concept is now well understood by many stake holders – investors, intermediaries and advisers. Moreover, availability of ETF building blocks across asset categories such as equities, sectors, fixed income and commodities has further increased their acceptance amongst various stake holders.
In India currently, a lot of ETF discussion is gravitated around volumes, tracking error and expense ratios and to some extent their pros and cons versus index funds – the other passive format. The importance of daily average volumes in ETF selection cannot be understated and investors understand that high daily average volumes are a critical criterion for ETF selection, i.e., within the peer group. However, there is not much discussion about other areas of ETF advantages – namely their high versatility, flexibility and hence there are many ETF strategies possible. The aim of this column is to focus on this important aspect of Exchange traded funds.
The simplicity of ETF structure makes it a favorite amongst investor categories – institutional, high net worth and retail.
Some of the strategies that can be implemented with ETFs are as follows:
We all understand that asset allocation is the prime mover of portfolio return, various studies have proven that more than 90% to 95% portfolio return is because of asset allocation. Asset allocation works on the principle that different asset categories such as equities, fixed income, gold / silver perform or behave differently under different market conditions. In other words, it can be said that since different asset classes are diverse in behaviour, hence they are not perfectly correlated. In simple words, asset allocation is diversification across asset classes and works on the principle of ‘don’t put all your eggs in one basket.’
Why ETFs are best suited for portfolio asset allocation?
An Exchange-Traded Fund (ETF) is a security that tracks an index – equity or fixed income, a commodity or invests in fixed income instruments. Hence ETFs represent an asset class and are best positioned to capture the properties, behaviour and characteristics of an asset class. In other words ETF mimics an asset class.
For example, a combination of Nifty50 and NiftyNext50 ETF represents the large cap segment of the market. Likewise, a Midcap150 ETF represents the midcap category, a Nifty Bank ETF represents the banking sector, Gold and Silver ETFs represent the respective commodities, and so on with various fixed income ETFs with G Secs, SDLs and CPSE bonds as underlying.
Asset allocation of the following types can be practiced using ETFs:
Strategic asset allocation
This is a long-term plan to create an optimal portfolio mix primarily between equities, bonds, commodities and thereby minimise overall portfolio risk. Since strategic asset allocation plans are long term in nature, and designed to meet long term financial objectives, they are generally agnostic to short term market movements or temporary economic conditions. Various ETF building blocks such as broad market equity ETFs when combined with commodities and select fixed income ETFs can comprise a strategic asset allocation plan.
Core and Satellite asset allocation
In such plans as the name suggests there is a core or foundation asset category which is the most significant component of the overall portfolio. Example, broad market ETFs such as Nifty50, Next50, Midcap 150 can form the foundation equity allocation as the investor can capture the index (market) rate of return consistently into the future. Satellite component which would ideally form a small percentage of the total allocation can be used to generate a return higher than the market. Smart Beta index ETFs which make use of various factors such as Jensen’s alpha, low volatility, momentum, value etc can be used to generate ‘alpha’ over the core beta indices.
Tactical asset allocation
Such plans are short term and the purpose is to quickly capitalise on perceived or expected short term movement of an asset class. For example, if one believes that silver can see a sharp upward movement due to global rise in demand of solar panels, a tactical move into this asset class is done. Sector equity ETFs such as pharma, IT, autos and banks can form a part of the tactical allocation. Even on the fixed income side, an investor can take tactical calls on the 5- or 10-year G Secs via those respective ETFs.
ETFs can be a good option to quickly deploy cash and thereby begin participating in the market.
For example, during the recent pandemic and the ongoing Ukraine conflict there have been many occasions when the markets have seen a substantial fall. Smart investors have taken advantage of this, quickly deployed cash via broad market equity ETFs and thereby started participation in the markets. These investors seized the opportunity of steep fall and did not waste time trying to figure out which individual stocks and fund managers to invest in.
Huge ETF volumes witnessed during recent market fall is proof that many investors have understood the advantages of cash equitization. Additionally, cash equitization can also be used as a strategy to place cash (earmarked for equity allocation) in between stock trades, when an investor is unsure or has not identified his/her next stock position.
Active trading with ETFs
Since ETFs are listed securities they can be used by day traders as well as short-term investors to capture market movement. Instead of trading in individual stocks, technical analysts can give trading strategies on broad indices or sector indices through ETFs. Doing this eliminates the concentrated or non-systemic risks that are associated with individual securities.
Actively Managing Longer term portfolio:
The simplest investment strategy is to buy and hold broad market indices. This is some kind of “fill it and shut it” strategy, to borrow the slogan of a famous motorbike ad.
However, some investors may want to proactively shuffle portfolios between asset classes, segments, themes and sectors. Example: a global crisis may warrant active entry into commodities like gold as it is considered as a store of value and a safe haven. Gold and Silver ETFs are available to take exposure to commodity as an asset class. Similarly, some government policy announcements such as proposed privatization of select
PSUs – this theme can be played through CPSE ETF.
Likewise, increased healthcare expenditure announcement in the Union Budget may warrant an increased exposure to the pharma sector via Pharma ETF. RBI announcements can move the 10-year benchmark and hence those ETFs can be actively used to capitalize on these central bank action. Since ETFs are listed securities – real time market movements can be captured through various policy announcements.
To conclude, ETFs provide investors with exposure to broad segments and sub segments of the equity markets, commodities, fixed income and money market thus enabling efficient asset allocation consistent with their financial needs, risk tolerance, and investment horizon.
A plethora of tactical, thematic, long- and short-term investment strategies are possible with various ETF building blocks.
The availability of ETF building blocks across broad market domestic and international equity indices, sectors, smart beta, commodities, fixed income, and money market makes them versatile / suitable for various investment strategies.
(The author is Head of ETF, Nippon India Mutual Fund.)