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How To Become A Seasoned ETF Investor in India
Recently, I was training a group of youngsters about the way exchange-traded funds or ETFs work in India. It was an interactive session with questions flowing from all corners of the room. ETFs are magical – the more you learn, the less you seem to know, but the better you can earn ☺.
Among all the questions pertaining to processes and regulations surrounding ETF investments in India, a young girl suddenly asked me, “Sir, you must be a seasoned investor, right? How can I become one?”. This was an omnipotent question – a seasoned ETF investor would be able to understand the ETF market, be aware of the various ETFs available, would be able to decode the effects of micro and macro-economic factors on the markets, have a clear investment plan, and choose ETFs that could help achieve these financial goals. I knew the answer, but it would be overwhelming for someone new to ETFs.
Hence, I decided to conduct a class on ‘How to become a seasoned ETF investor in India’ instead. Here is a creative transcript from the class that can help you become one too!
ETFs or Exchange Traded Funds are mutual funds that can be traded on a stock exchange like shares of a company. They can be likened to Index Mutual Fund where the portfolio tracks an underlying index by investing in securities in the same proportion as the index.
For example, an ETF can track the Nifty 50 Index, wherein it purchases stocks from the index so that it can replicate the returns provided by the Nifty 50. ETFs are different from Index Mutual Funds as they can be traded in the secondary market.
Understanding Direct & Indirect Investments
As an investor, you always have a choice between investing in an asset directly or indirectly. For example, you can buy physical gold (direct investment in the asset) or opt for an investment instrument that tracks the performance of gold by investing in it.
While direct investment requires a good knowledge of the asset and the markets, indirect investing allows relatively inexperienced investors to buy instruments that are managed by professionals. This allows them to avoid bad buy/sell decisions and earn better returns.
Why ETFs over Mutual Funds?
You can invest indirectly via Mutual Funds and ETFs. While mutual funds are preferred by most investors, they have certain limitations. The biggest advantages of ETFs over mutual funds are the availability of real-time prices and the ability to trade. ETF units are traded on the stock exchange in real-time. Hence the market price of an ETF unit keeps changing. This gives ETFs the flexibility of stocks with the benefit of a portfolio approach of a mutual fund.
The class was highly attentive. I could have heard a pin drop. Everyone seemed to be understanding the concept so far but I thought of easing the mood a bit. So, I asked the students if they had any questions. And yes, there was one:
Question: ETFs track an index. This means they can offer returns as an index does. But mutual funds offer better returns than an index, right? So, how are ETFs better?
I liked the way the class had started understanding ETFs and investment markets in India. Asking the right questions was the perfect way of learning. Answering the question, I said:
Mutual funds CAN outperform the index. It is important to remember that it is not a certainty, but a possibility.
Hence you cannot be sure that a mutual fund will outperform. There can be times when it might under-perform leading to losses. Fund managers of mutual funds actively manage the portfolio to make purchase and sale decisions to ensure that they earn market-beating returns.
ETFs, on the other hand, have a passive management approach where the fund managers simply track the index without analyzing the market. Hence, your losses are curbed while your profits are limited too. Hence, ETFs are a balanced approach to investing – lesser risks (due to passive management) and market-linked returns.
While you can trade ETF units any time during the day, the ETF follows a passive investing strategy. This means that the fund invests in securities and forgets about them. It does not analyze the market and try to make changes to the portfolio for maximum returns. Instead, an ETF follows the composition of the tracking index.
Passive Investing is also called a buy-and-hold investing strategy. It involves purchasing assets in line with an index that you want to track. This reduces the decision-making risks and offers returns similar to those offered by the index.
ETFs are a perfect example of passive investing since there is no active management involved. An ETF tracks an index and purchases securities in sync with it. Come to think of it, passive investing has the best fund manager there can ever be – THE MARKET – that determines the returns. Passive investing also leads to lower fund management costs since the fund does not require a manager with expertise in beating the market. Hence, ETFs are cost-efficient thanks to the passive investing approach.
There are four main aspects that you need to look for before selecting an ETF to invest in. Let me explain these in detail below –
#1 Theme of the ETF
ETFs can be based on equity, debt, gold, or global indices. Under each of these segments, there is a further classification based on the market segment that the fund tracks. Before selecting one, it is important to understand the theme of the ETF and ensure that you want to invest in that segment.
For example, you might want to invest in the broad financial markets of India while the ETF might just be tracking the banking segment. Hence, this ETF will not be in sync with your preference.
#2 Demand and Supply of the ETF units
When ETFs were initially launched in India, the trading volumes were low. Hence, investors were unable to sell the units when they needed funds. Over the years, the volumes have considerably increased. However, some ETFs tend to have lower trading volumes than others. In order to get a good market price for your units and high liquidity, it is important to select an ETF with higher trading volumes.
#3 Minimum Tracking Error
Tracking error means the difference in returns offered by the fund versus the index that it was tracking. While an ETF closely follow the underlying index, there is always a possibility of a slight difference between the returns of the ETF and the index. As an investor, you need to look for an ETF with the minimum tracking error to ensure that you get returns closer to those offered by the index.
#4 Cost of Investing
The cost of investing or the expense ratio for an ETF is lower than a mutual fund since it is not managed actively. Some fund houses try to extend the maximum benefit to investors by slashing the expense ratios. However, some others might extend further discounts too. Look for an ETF with a lower expense ratio to reduce your costs and increase the returns.
Some Seasoning to the Mix..
The hallmark of a seasoned investor is identifying his investment requirements by assessing his financial goals, risk tolerance, and investment horizon. Using this information, he can create an investment plan that works towards making his financial goals a reality. It is important to be reasonable in your return expectations from an ETF since it is not actively managed or designed to beat the markets. If you are an aggressive investor or have an aggressive growth agenda from your investments, then you might want to dedicate a smaller portion of your portfolio to ETFs and a larger chunk to stocks.
As I ended the session, most students had a glint in their eye. They finally had the secret formula of becoming a seasoned ETF investor in India. I was hoping that I had lived up to their expectations and given them all the information they needed to venture into ETF investing.
A few days later, I was talking to some colleagues at Kristal.AI and was trying to understand the range of ETF products offered by them. Kristal believes that after the launch of the Bharat Bond ETF, the Indian ETF market is poised to gain popularity and investor trust. Over the next few years, we can expect a wide range of different ETFs to hit the market. I wonder if my students already knew that this was coming and was preparing themselves for the long haul! ☺
I hope that along with my class, you also have a fair idea about what you need to learn and do to become a seasoned ETF investor in India. If you have any questions, please feel free to mention them in the comments below and I will be happy to reply.
As I see it, the ETF wave is coming, and it will be sound investment advice to ask you to be prepared to make the most of it. Good Luck!
The materials and data contained herein are for information only and shall in no event be construed as an offer to purchase or sell or the solicitation of an offer to purchase or sell any securities in any jurisdiction. Kristal Advisors does not make any representation, undertaking, warranty or guarantee as to the update, completeness, correctness, reliability or accuracy of the materials and data herein. All opinions, forecasts or estimation expressed herein are subject to change without prior notice. Kristal Advisors and its affiliates accept no liability or responsibility whatsoever for any direct or consequential loss and/or damages arising out of or in relation to any use of opinions, forecasts, materials and data contained herein or otherwise arising in connection therewith.
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