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Investing Beyond Borders | Hedging with ETFs

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In our last article, we gave you complete details on how you can invest in international stocks to hedge the depreciating rupee. There is another tool that is available to Indians in order to participate in the US markets: Exchange Traded Funds (ETFs).

What is an ETF?

An Exchange Traded Fund or ETFs as they’re popularly known as, like a Mutual Fund, is a portfolio/basket of stocks. What sets them apart from Mutual Funds is that an ETF can be traded on the exchange just like an individual stock.

In essence, an ETF is created like a Mutual Fund and traded like a stock.

A Very Short Introduction to ETFs

ETFs as we know it today have been one of the most innovative products introduced by Wall Street. The first modern ETF was created by State Street Global Advisors in 1993 and was named the SPDR ETF. It tracks the S&P 500 Stock Index and is the largest ETF in existence with assets of around $58 billion. According to data from ETFGI, there is $4.5 trillion under ETFs as of November 2017.

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Growth and expected growth of the ETF sector over the years.

But, Why Should You Invest in an International ETF?

1. Lower Operating Expense Ratios

ETFs have a lower expense ratio as compared to Mutual Funds that invest in international markets. Here is why:

A) Most ETFs track the indices which take away the cost of active management

B) ETFs are traded on the exchanges, unlike a Mutual Fund where an investor can redeem his/her units only after contacting the fund house. Thus, ETF does not involve the extra cost associated with the complex redemption procedure of the fund house.

To put things into context, the expense ratio of an international Mutual Fund in India averages around 1.5% whereas the average expense ratio of an international ETF is 0.3%.

2. Easily Tradeable

ETFs can be bought and sold on the exchanges just like any other stock. The Net Asset Value (NAV) of an ETF fluctuates on a constant basis like stock prices.

3. Diversification

ETFs normally hold 70 to 80 stocks under them which provide diversification. Additionally, ETFs are available across all sectors and categories, i.e., there are ETFs that focus on tech stocks or the mining stocks and so on. For investors who want exposure to niche and less explored sectors, ETFs serve as a perfect tool.

Who Should Invest in an ETF?

ETF is an apt option for first-time investors in the global markets. It solves the problem of self–research, daily tracking and possibility of narrow concentration. ETFs are also apt for investors who wish to invest in international markets with a long-term horizon of greater than 5 years and do not hope for active management of their portfolio.

“ETFs have become the optimal choice for portfolio allocation, and this trend is definitely going to continue,” said Matthew Bartolini, head of SPDR Americas Research at State Street Global Advisors.

But Why is the Focus ONLY on International ETFs?

Markets in developed countries like the USA are transparent and are termed as efficient markets. In such markets, the difference in an actively managed portfolio vs. a passive portfolio that tracks the indices is not large.

Hence, it makes sense for an investor to invest in an ETF that tracks indices and lowers the expense that he/she would pay to the fund manager.

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The graph shows the closing gap between active and passive funds globally as markets become more efficient and the need for active management is reducing. The gap would be more prominent in developed markets like the US.

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The table above has data points for the 5 biggest ETF providers in the US which manager more than 89% of all ETF assets in the US as of 2017. As per the data, the ETF sector has grown by almost 32% from 2016 to 2017.

How Do You Pick an International ETF?

Just like in Mutual Funds, investors have a number of options to choose from in the ETF universe which consists of more than 2100 ETFs.

Here is our short guide for you to narrow down on the right international ETF for you to choose:

Step 1: Assuming you want to hedge against the dollar you would select an ETF that invests in the US markets. For people who wish to do otherwise, your first step would be to determine which geography you wish to get exposure to.

Step 2: Select the sector/category of stocks you want to gain exposure to. For example: In case you want exposure to large-cap stocks you can invest in an ETF that tracks the S&P 500 Index such as State Street S&P 500 ETF. Or, in case you wish to gain access to countries across the developed markets you can invest in an ETF such as Vanguard Developed Markets ETF which invests in a diversified group of stocks.

Step 3: Analyze the ETFs available under the sector/category you have chosen on the basis of expense ratio, tracking error, past performance and so on.

Step 4: Shortlist the ETF that most aligns with your goal and you should be ready to start hedging it right and become a global investor! 

We would definitely like to learn about your thoughts on the same. Let us know your queries or suggestions, in the comments section below or write to us at hello@kristal.ai. If you would like to explore how you can grow your wealth based on specific financial goals, sign up at www.kristal.ai, and we would be happy to help you.

 

Disclaimer

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.