Photographer: Brendan Smialowski/Bloomberg News

The Mutual Fund Show: Should Investors Opt For ETFs Over Active Funds?

The heightened market volatility in 2018 took a toll on the performance of large cap schemes as exchange-traded funds—which track an index, a commodity, bonds, or a basket of assets—managed to beat “actively managed funds” by providing superior returns to investors during the year.

ETFs are managed passively and provide returns very similar to that of its underlying index. This is different from an actively managed fund, where the fund manager “actively manages” the fund and continuously trades assets to generate alpha—the return in excess of underlying benchmark.

“Active management will continue to have the potential to generate alpha by outperforming the benchmark. However, this has become increasingly challenging over time, especially in the large cap space,” said Anil Ghelani, senior vice president and head of passive investments and products, DSP Investment Managers on BloombergQuint’s weekly series, The Mutual Fund Show. “While the debate of active versus passive will continue globally, what Indian investors really need is a blend of both.”

Dhruv Mehta, chairman at Foundation of Independent Financial Advisors, disagreed. ETF, according to Mehta, continue to face the problem of liquidity as it’s still in a very nascent stage in the country.

Watch the full conversation here:

Here’s the edited transcript of the conversation

What are ETFs? How do they go about investing in ETF? Is this a right option for retail investor versus something else?

Anil Ghelani: It is important to understand that one should not look at ETF as a sole (investment) vehicle. You have two options. One can be ETF or index funds. ETF is the fund which is traded on exchange. So, one must mandatorily have demat account, broking account to access that ETF.

It could very well be that the index funds can be easier option and a different alternative to buy that underlying benchmark. So, investing in index fund could be better passive allocation for a retail investor. Though I am heading the passive investments, as an investor at heart, I still feel strongly that in India, there is a scope for outperforming the benchmark or delivering alpha. However, it is becoming more difficult to deliver alpha in the large cap space. So, an investor should consider both—active and passive. Some part of the core allocation into equities can come at a low cost through a large cap passively managed fund and that will continue to be core holding on an ongoing basis and the other part of portfolio allocation into equities can go into a few large cap actively-managed strong funds which have a long-term track record of outperforming the benchmark, not just one year as it’s small period of time, and not just past performance but the way the process is worked, the way in which fund manager team operates in terms of identifying the companies and hence one can judge the future of outperformance.

What is an ETF? How do I go about doing it (investing in it)?

Dhruv Mehta: ETF stands for exchange traded fund. It’s a fund structure, but it’s a fund which gets traded only in exchanges. In recent past, the government had come with an ETF where stocks of state-run public sector units have been bundled and offered to investors for subscription. Once the scheme is subscribed to the ETF, then it gets listed on the exchange. Once it’s listed on the exchange any investor theoretically can buy and sell.

In India today, ETFs are at a very nascent stage. There’s not that much trading happening in the market. Like Reliance shares, it’s easy to trade in terms of volume and liquidity. Therefore, there is not much of a beta spread between the prices. One is very clear that what price you get is a reasonable price. In stock market, if you are buying an illiquid share, sometimes there is a big gap in prices at which you buy and sell, although there is no change.

For example, there is ETF Nasdaq 100 which is listed. It gives an opportunity to retail investors to invest in Nasdaq but actual trading is not liquid. It is not as simple as you call your broker and say buy me 100 shares of Reliance. You call and say get me 100 units of ETFs. It’s not that popular.Theoretically, it is possible. When you call your broker, he will get the quantity. If you have subscribed to ETFs in new fund offerings, there will be a problem when you liquidate. In the exchange, if there is no liquidity, there is no buyer for big size, then you must go to the issuer and issuer must buy and sell the underlying stocks which is a little painful process. For retail investor, that option is not there.

Have those ETFs, by virtue of lower cost, managed to give you better returns? If somebody is looking to invest in large cap funds or index funds, then is it a better strategy to invest in ETF if I have 10-15-year horizon?

Dhruv Mehta: When you are putting in an index fund or ETF, you are assured of the average return or return on index which is average of all stocks put together. If you’re clear, that whenever I will get that return I will be satisfied. In market,you will have index funds and active funds. There will be periods when active (funds)will do better and that can be a huge difference like the index is 10 but the active fund manager gives 15. At that point of time, you should not change your strategy. Past returns, if they start determining past returns your strategy,then this is notional. To get the benefit of the savings and cost, you have to remain invested for 40 years. In last five years, you will find that over a five-year period, there will be period when large cap funds gave 5 percent return after expanses better returns than the index. At that time, you will feel I’m getting 10 while large cap is giving 15. So, it is important that when you get into an index fund and for a long term and you say that very certain the cost will be lower, and my return will be average. But human nature is not satisfied with average return. If you go back a year, people who are not satisfied with large-cap return, they wanted the mid-cap return. Then they found that small cap is giving higher return than they would.

Your objective and mindset are very important. Globally, the pension funds, the large universities and endowments, when they make the allocations to equities,they are taking country exposures and they are deciding to take the ETF routes because they are going to invest for 30-40 years. They say I am happy getting average return, but I don’t want to take a risk that a fund manager underperforms, and I am ready to let go higher return because I don’t want to take that risk. So, the investor psyche should be that over the long period I’ll get average return.

If that isn’t the mindset, then today in India, there is a case for active investment because India is not a discovered market. Therefore, (for) somebody doing research, there’s good probability that he can create a portfolio which is better than the index. When you compare index and portfolio, generally all the indices are based on market cap weight. So, the largest company has the greatest weightage and when largest company do well then index will do better than the active. Last year, Reliance and TCS, within the 30 companies also, the biggest companies did the best. So, you have to keep (that) in mind as it will help in understanding why the index or active does better.

For somebody not wanting to go in mid cap and small caps but only stick to large caps to beat the benchmark, would passive or ETF investments is better than large cap investing?

Anil Ghelani: I agree. In large-cap space, cost is an important factor. If you are in mid- and small-cap space, then you have huge scope and potential for generating the alpha as you can identify stocks in a better manner. In large cap space, there’s finite pool. It’s important to recognise that about a year ago, SEBI classified large cap funds in a clear-cut manner.

Where do you park your money in larger variety? Would you be comfortable with actively managed large cap funds category or would you put money in lower expense category at this point with a 10-year horizon?

Dhruv Mehta: I believe that even in large cap space, the alpha is not there in last 1-3years. But over 10 years, even in large cap space there is a possibility of alpha generation. If you are looking at Nifty 50 stocks, the allocation of first 5-6 stocks, like Reliance and TCS make up the top and that’s what will contribute. If you go to 50th stock, the allocation would be 1percent or negligible. In investing besides stocks selection, allocation is important of how much to allocate to each stock.

An equal weighted index is better than a market cap-weighted index. Compared to an equal weighted index fundamentally weighted index in the sense that allocation which I invest in company should not be determined to its market cap. It must be determined by the fundamentals of that company. This is my hypothesis. That in long term, a company which does better will give you better returns. Not necessarily,the company with the highest market cap.

If you seethe U.S. history, as markets become more institutionalised, you have passive and active money. So, it is zero-sum game. Whoever is buying, whatever is the total return in market, somebody makes more than that or somebody will lose.The total return cannot change as it is arithmetic. In investment framework,you have professional managers and retail investors. With the rise of mutual funds in USA. In 1990, US was about 8-9 percent AUM (assets under management) to GDP and we are about 10-12 percent. Today, US is almost to 100 percent AUM to GDP. At some point in 2000s, the institutional was more than retail investor-based.It’s completely institutionalised market. Professionals are playing against professionals. Therefore, the alpha spread has narrowed, and they’re not making. India will take 10 years to become a fully institutionalised market.Therefore, active fund managers have a big role to play by way of allocation and selection. The SEBI categorisation is giving you spread of 100 stocks whereas Nifty is 50 stocks.

Anil Ghelani: Though there are only 100 stocks, but they are extremely well researched. So,the concept that the fund managers are playing in that define boundary or pool of stocks which are well researched already, if you have leeway of going down beyond 150 an buying few of stocks which are 300th or 500ththen I have my skillset to bring in power and buy few stocks which will give me a kicker.

My personal allocation, 100 percent of my large cap exposure, every month from my salary I draw a certain percentage which goes to large cap which is going to passive fund which is DSP Equal Nifty 50. One allocation is going to SIP into a mid- and small-cap fund. Third is going to ELSS (equity-linked savings schemes) fund through the 12-month period. In the ELSS and mid and small, the allocation of your portfolio manager is multi-cap. Leave out the multi-cap and small cap, in large cap 100 percent is going to passively managed fund. I am aligning with low cost. It is a complementary strategy accessing your equity allocation.