The Mutual Fund Show: Will A Bond ETF Be A Safer Bet For Investors?
Investments in commercial papers of IL&FS group, Essel Group and Anil Ambani group by asset managers had triggered concerns.
Investments in commercial papers of IL&FS, Essel and Anil Ambani groups by asset managers had triggered concerns about debt mutual fund schemes. Can a bond exchange-traded fund be a safer alternative?
There couldn’t have been a more relevant time for the launch of the product that is awaiting approval from the Union Cabinet and is expected to be launched by the end of the year, said Radhika Gupta, chief executive officer at Edelweiss Asset Management. The government had appointed Edelweiss Mutual Fund, earlier this year, to manage an ETF holding bonds of public sector companies.
Debt ETFs not only assure better returns than fixed deposits but are more transparent, liquid and cheaper and will be governed by a set of defined parameters, Gupta said in this week’s episode of The Mutual Fund Show. She hopes this bond ETF could soon reverse the fear and stigma related to debt mutual funds. Gupta, however, said liquidity might be a challenge for the product in its infancy but will find its way in debt ETFs over a period of time.
Tarun Birani, founder and director of TBNG Capital Advisors, doesn’t expect the product to be suitable for retail investors as usually, only institutional investors opt for debt or ETF products. “The structure and dynamics of the new products are yet to be studied in the detail,” he said, adding that he doesn’t expect the product to deliver greater returns than existing debt mutual fund products given that underlying instrument of investment would be central public sector enterprises.
Watch the full show to learn more:
Here are the edited excerpts from the interview:
Tell us a bit more about bonds and ETFs because it’s like Greek and Latin for everybody in the Indian ecosystem.
Radhika: It’s interesting that at your show and everybody else has been talking about passives and ETFs coming to India in a big way. Strangely, the assumption has been that ETF only includes equity and passive doesn’t have anything to do with fixed income. Globally, bond equities and bond ETFs are a one trillion-dollar asset class and is very relevant. When you think of the Indian context, I actually think that the actual discussion of passive funds is far more relevant for bonds than it is for equities. Let me tell you why. If you look at what a passive product brings to India, it brings essentially three things, the first is liquidity.
Liquidity has always been a problem in the bond market, it is something that people have talked about, it’s very difficult for an individual investor to buy a bond today. If I wanted to go out and buy one of these good government bonds, it is very difficult to do that. Transparency is the other thing that ETFs bring because they are benchmarked to the index. For the last year that we’ve been talking about the NBFC crisis, we’ve talked about the challenges in the mutual fund portfolio disclosures, knowing your portfolio once a month. Within ETF, you know your portfolio daily—that’s important to the bond market. Most importantly is cost. Bond mutual funds have a price but cost matters more when returns are lower and in fixed income, your returns are 6-7-8 percent, so any cost-saving that really hits the bottom line faster than it does in equities. So, that is why I think the bond ETF conversation is the most relevant conversation from a passive point of view.
So, tell us, what is the nature of this product? What are the details that one should and would have in mind? Any timelines thereof, anything?
Radhika: I think there’s a beginning of the bunch of conversation on this. But if you look at where bond ETFs are and started globally and what bond ETF’s do. A bond ETF is just like an equity ETF. It’s a mutual fund product that trades on an exchange. Just like equities, a bond ETF is benchmarked to an index or bonds. Now, that index could be an index of government bonds, it could be an index of public sector bonds, it could be an index of three- to five-year bonds, it could be of five- to seven-year bonds, it could be of seven- to ten-year bonds.
Once that index and its rules are defined, then the ETF has to follow that in entirety. There is no fund manager discretion or random credit popping up or random duration calls. You know what you are signing up for, that portfolio is by the way published daily on an exchange or a third-party website and your bond ETF mirrors that which is my point about transparency. The third thing with the bond ETF is that it trades on an exchange. You can buy and sell that daily on an exchange. There are intermediaries called market makers who are there to facilitate the buying and selling. Unlike a fixed deposit and an FMP for example, where you put in money and it’s locked in for three years, your money is available on call. So, you have the features of liquidity and transparency.
A few of our viewers might be wondering how is this any different from the existing debt market products that are anyway there. If I put it in a bond fund, for example through my agent, if I liquidate it, the money comes into my account the next day. If I put it the next day, I can still do that. So why is that, that this bond ETF is special?
Radhika: So, let me compare bond ETFs to the two or three traditional instruments that your viewers may look at. One is bond mutual funds, second is fixed deposits because they are our favourite instrument and the third is, buying bonds. There are a lot of NCD issues and such kind of products out there. I think versus (compared to) individual bonds, it is very difficult for your average viewer to go out there and buy a bond.
There’s no transparent mechanism to go and buy a bond. Often, you need to put an amount of Rs 10 lakh odd as a minimum lot to even purchase a bond. The coupons by that bond are by the way fully taxable versus an ETF carries the same debt mutual fund taxation. So that’s the advantage versus individual bonds. Also, remember a bond ETF is a diversified portfolio versus a single bond where you are carrying a single issue on that.
So, no concentration risk on that?
Radhika: No concentration risk. Liquidity, transparency and I think that’s the difference between a regular bond versus an FD, some big advantages are that FD I think is a single bank and I think FDs are locked in and there are a lot of breakage and prepayment penalties. FDs for high tax rate investors are fully taxable. Bond ETFs don’t have those challenges. Versus bond ETF mutual funds, there are two big advantages. Bond mutual funds can be redeemed every day, I agree. Some of them have liquidity constraints. The first big advantage is transparency. In a bond mutual fund, it is the fund manager’s call as to what he wants to do.
In a bond ETF, you know exactly what you are getting. So, for instance, if you buy a dynamic bond fund which is a common category of mutual funds, It could be holding a five-year duration, a three-year duration, or a one-year duration on the basis of the fund manager’s call. It could be holding a Double A paper, a Triple A paper, some double A, some triple A. You don’t know what you’ve signed up for. In this case (bond ETF), all the parameters are defined. A typical bond mutual fund also costs about one odd percent (Fifty bits to one percent). I can tell you a bond ETF is significantly cheaper than that.
So, you are almost making it sound Radhika that the advent of this; in a manner of speaking, puts out the death knell for people who understand all these products, puts out the death knell for maybe fixed deposits maybe in some cases even bond funds because this is a far superior product. (Is that the case)?
Radhika: Look, I have to say it’s a product that we’re super excited about. I must also tell you that the bond ETF understanding is fairly limited. There are multiple kinds of bond ETFs also that are out there in the market. If I could just be going to this for a second, they are broadly globally and over the last year we’ve been studying this. There are broadly two kinds of bond ETF products that are out there in the global market. The space started evolving. If you look at the global bond ETFs, they copied what global bond mutual funds were doing.
So, there is a concept called an ‘All Term Bond ETF’ which is very similar to your bond fund. Typically, you’ll have a three-to-five year duration and the bond funds will hold bonds with a three- to five-year duration and a certain credit quality etc. As bonds mature, new bonds will keep getting added. So, that’s your ‘All Term Bond ETF’ structure. (It) could be three to five years, could be five to seven years, could be seven to 10 years.
There is a second and more interesting category that evolved in the global markets. Blackrock has a really interesting product called Ibond. That’s called a target maturity structure and there the maturity of the bond or the bond ETF is defined. So, you launch a for year target majority structure in 2019 and it will hold bonds that mature in 2023. So, if you hold that product for four years, it’s actually very similar to a bond and you know kind of starting today what you are likely to get. So, bond ETFs also come in all types.
There are bond ETFs that look more similar to a bond mutual fund and then there are these bond ETFs that look far more similar to your FD or bond in characteristic. I actually think the second one is a very interesting structure for the Indian context and the Indian markets because we essentially as bond investors we don’t—I mean our understanding of duration of credit is relatively limited. We seek predictability in our bonds. I mean we invest in bonds for safety and I think the structure gives you something of that sort.
The timing if at all this comes about in the next two, three, five or six months is also interesting because it’s coming subsequent to 12 or 15 months of not necessarily turmoil but scepticism around the offerings from the mutual fund industry as far as the credit thing goes, right? I mean nobody thought that you will need advice for credit funds or debt-related funds. Now everybody thought that equity funds are okay, we probably need some advice for credit funds and if this is transparent—liquid enough if it’s like you’re going to be liquid enough in this product, then it probably provides a real and definitive alternative to people who want to put money into fixed income as opposed to equities?
Radhika: Yeah, I think you make a very relevant point. When the offering is launched, it comes at a time where people ask a lot of questions. In fact, I think when I meet advisors and investors, they’re more scared by debt than by equity, which is not a desirable place to be. I often say that if you judge the bond MF industry by what happened in the last one year and run away from bond funds as a category (because they carry a huge tax advantage), then that is a big tragedy and I hope something like that will be reversed with products like the ones coming up. So, it comes at a very relevant time.
There’s an interesting statistic that our FD market is more than Rs 100 lakh crore. Probably in excess of Rs 150 lakh crore. I don’t know if you know the HNI and retail participation in bond mutual funds. Rs 90,000 crore for retail, Rs 3 lakh crore for HNI. So, it’s a very small number. So, it also comes at a time when despite everything that has happened with mutual funds, SIP has become a movement, but bond investing has not become a movement and it better. (This is) Because, 50, 60, 70 percent of your portfolio is going to be a fixed income. Mutual funds will not become mainstream until you win the fixed income battle.
What could be the potential concerns here? I’m sure that when you’re talking about this, there are some global experiences which speak about there being one or two drawbacks or concerns if at all and because it’s a new thing in India everything that is new faces two issues: one is acceptance, two is liquidity.
Radhika: I think liquidity is going to be the primary question.
Why so?
Radhika: So, it is a known fact that equity ETFs haven’t taken off in a big way in the retail population in the Indian context. Therein, AUM has largely been institutional. I believe equity is a very different argument from bonds because I think in equity, you have very comparable alternatives and active funds have done well. So I don’t think equity is a great proxy but even there people have raised questions about liquidity to be honest. I think that when we do put out the bond mutual fund product, liquidity will be our highest priority.
There are mechanisms globally. So, if you look at globally how liquidity has been created in ETFs, there is an institution called ‘Market Makers’ that plays a very important role in providing liquidity. They make sure that there is enough supply and demand of the product so that if you as an investor want to sell the product on the exchange, someone can sell it to you at a reasonable price and at not a material discount or premium. So, that infrastructure is very important, and I think that’s the most common question people will ask. Other than that, every bond ETF will come with its own characteristics but as long as the portfolio is high-quality. I think you’ve got a transparent low-cost product in the offing.
But there wouldn’t be a challenge for an individual retail investor to move in and out in the initial stages or would there be?
Radhika: I think if the AMC is able to take care of liquidity, then there should not be a challenge and I think the real challenge for the AMC is to make sure that liquidity is adequate so that if the yield of the bond is 7.5 percent, the spread up and down is not material.
Who do you see this most suited for? Because a lot of times, there are products that for example a lot of our viewers write to us about things that they want to and they’ve heard somewhere and they want to invest in long-short funds etc. These are highly institutional specific products so who do you think this bond ETFs would be the most suited for? What kind of investors? What category?
Radhika: We’ll share more as the product structure comes out. We would hope that Bond ETFs form a part of the core medium-term bond allocation. So, outside of your liquid and all that short-term stuff. This is not short-term in nature, but we would hope that this stuff forms a core part of your portfolio allocation and bond ETF’s are meant to take a simple asset class which is fixed income and simplify it further. So, in that sense, they are suitable for basic investors they’re exactly the opposite of what you said in terms of long short funds, quant funds and some of the more complex pieces out there. They’re a simple product meant for simple investors who just want a basic return from their portfolio.
Bond ETFs is something that has not seen the light of the day thus far likely to come in. What are your initial thoughts on the same?
Tarun: If I look at the entire market size today, the Fixed Deposit market as we speak is a Rs 40-lakh crore market. The mutual fund industry is a Rs 25-lakh crore market and out of that Rs 10-11 lakh crore is debt category. It’s a very big category and capital protection as well as stability is one of the biggest features which a debt product gives. I see a very big potential for this category in future also because as an advisor I see the protection and the stability part as something which debt is the only product which can get us there. There is a lot of potential for products like debt ETFs, but we need to see how things are going to pan out because ETF as an Equity, if I talk about the experience of Equity ETFs in India is not been that great. It has been challenging for the simple reason may be it is driven out of equity market and equity markets have its own shares of ups and downs but if I look from 3-4 different angels, one is from cost perspective ETF look as a very cheap option. From a liquidity point of view, it is an extremely challenging thing today for anybody investing in a single bond and getting liquidity out of it is a challenge today which this bond ETF structure is able to, and globally I think, it has been a successful model and that is the biggest gap this bond ETF is going to help us. And transparency, I am sure with bond ETF, with day to day NAV calculations, day to day transparency and liquidity, I think, transparency will be much higher thing for the debt mutual funds which we have today.
What could be the challenges here? Radhika Gupta was saying that for anybody who wants be better than FD returns or otherwise as an alternative to the fixed deposits even for a retail investor a bond ETF could be a good option because it will be diversified in nature and not concentrated and two, as and when market develops it might become a bit more liquid as well. What are your thoughts on the same?
Tarun: It is too early to comment on that part. I want to see the finer details of the product. Let it come out in the market then we can talk more in detail about it because it is an evolving product and category which is developing in the market. I am not sure how it is going to take shape but looking at sovereign or government-oriented bonds forms part of these ETFs it can really help us creating a lot of trust, we can build up on these bonds in the market.
Let me rephrase my question. Based on whatever little knowledge you have about this and of course the vast knowledge you have about the other fixed income products available, who would need to go and invest in a bond ETF. Are there any particular kind of investors who are currently investing any kind of fixed income categories wherein the bond ETF, if it is liquid enough might give the better bank for the buck?
Tarun: My experience with the debt mutual fund and bond ETF versus debt mutual fund this is the closer competition I would talk about. I have seen more sophisticated and more HNI-oriented clients or the institutional clients are the ones who are investing more in the debt category. I have not seen that kind of retail participation coming in the debt mutual fund and again debt ETF has a problem, you need to have a Broking account or a Demat account, which again could be a problem wherein a retail investor cannot get in there and it is too complicated to put a trade for it. I find it very challenging in terms of debt ETF taking off smoothly in the market. These are some challenges I can see. How they are able to solve it. Like in Gold ETF, they are able to solve it by making a gold mutual fund which in turn buy ETF.
The execution challenges are one thing. Would the returns be far more superior because if returns are there and superior over a five-10 year period, then people might even take the pain of doing all that you are saying. Would the possibility of returns be superior compared to the existing fixed income category?
Tarun: I don’t think so. Returns will be much more superior because at the end of the day you have all these government bonds available today also. End of the day underlying is all these government securities only. So, the returns, I don’t see that is going to be superior. Liquidity is one very big challenge which they tried to address. But return point of view I don’t see that because taxation and everything is similar. So, I don’t see anywhere else post tax returns will be much higher.
I also want to move angles a little bit and talk about gold, simply because of the kind of interest that gold has generated. The last couple of months there has been a significant inflow in gold-linked ETF flows. Can you talk a bit about this whether it is a good idea to make an investment here and between a gold ETF and a gold fund what would you choose and why?
Tarun: We Indians love gold. I was reading the numbers today and Indian gold market is around approximately Rs 75 lakh crore is a gold market, real estate is a Rs 80 lakh crore, mutual fund is Rs 25 lakh crore, fixed deposit is Rs 40 lakh crore. As you can see, gold is one of the biggest asset class and we Indians love physical assets, we love gold. I feel gold is not an asset for wealth creation. In turn if you look at any asset which can help you create wealth you need to have a capital appreciation; gold doesn’t have a capital appreciation. It only works because of greed and fear, if you see the underline. No interest or dividend comes out of it. So, this is a challenge of gold per say.
Fundamentally, but history shows that there is capital appreciation?
Tarun: Appreciation. But if you look at last 30-40 years returns, they have been between 8-9 percent CAGR. They are inflation-linked returns so it’s not a wealth creation asset. This is one myth one needs to break is that gold cannot give you double the inflation kind of returns, but you end up taking a lot of risk in gold also because the price is volatile. So, I always tell my clients that gold should be part of your portfolio for your social requirement, not for a wealth creation objective. It should not be more than 10-15 percent of your overall net worth. That is one cardinal rule that we follow at our clientele. Talking about the second thing, the vehicles, how can we invest in gold? There are gold ETFs available and a couple of years ago sovereign gold fund came into the market. I will try to compare both these products with five different parameters. The first parameter is in terms of the transaction charges, sovereign gold fund is the cheapest available. There is no expense in that product while the ETF will always have the expense. Talking about liquidity. From that point of view, sovereign gold fund is an eight-year product and after fifth year only liquidity comes in so there is no liquidity in that. In terms of ETF, you always have liquidity available. In terms of interest and that is one very interesting feature—2.5 percent interest what this sovereign gold bond generates compared to the ETF. In terms of taxability, again there is a catch there that sovereign gold fund, if you hold it till maturity for eight years, it a completely tax-free product for you. In case of ETFs, you end up paying the debt taxation more than three years in taxation benefit. I think one very superior feature about gold ETF is the regular investment and that’s where anyone can do a monthly investment planning in gold ETF compared to sovereign gold fund—there is no timeline available for that. So, these are five different features. If you are looking at a lump sum investment, a one-time investment sovereign gold fund is a wonderful vehicle. In terms of regular investment, gold ETF is a wonderful vehicle.
The other comparison Tarun and I think, a lot of people tend to do that, people still don’t know the differences between a gold fund and a gold ETF. Wondering if you believe that gold ETF might be a better bet than gold fund simply because I presume gold funds will eventually go out and invest their money in various gold ETFs and therefore the expense ratio could be higher?
Tarun: No, so here what I have compared is just a sovereign gold fund. This is issued by the RBI. Government of India guaranteed kind of product so that’s a different product. We are talking about a gold mutual fund versus a gold ETF. Gold mutual fund in turn invests in gold ETF.
Between the two, would you prefer that the viewers should go in for gold ETF compared to gold fund?
Tarun: Again, it depends on the sophistication level. So, gold mutual fund is good for somebody like a normal mutual fund they can do a SIP very easily. In terms of gold ETFs, you need to have a broking account or a Demat account. You need to punch in the order, which I think a normal investor will not have that kind of sophistication available. So, based on your convenience and understanding, one can look at it.
Any piece of advice, there is a clutch of things that has happened in the last few days and weeks. Some AMCs have seen CIO changes, there have been some significant market rally as well and people’s whose SIPs were on have seen those SIPs gains on some grounds as well. We are just shifting tracks for one last time. Would you believe that at this cusp of market, people should book some profit out of their mutual fund investments or would it pay to stay invested simply because the markets look like picking up?
Tarun: I will continue with my boring advice all the time which I keep giving. Asset allocation is the most important thing. Focus on your purpose and goal and all these noises will always be there. Every three to six months there is something or the other news keeps coming in. Focus on your asset allocation and objective part. If your objective and goal is very clear and if you have a longer horizon, I think suitability exercise can help you understand how much and where to invest and keep that kind of horizon, keep rebalancing, keep reviewing and that is the mantra. No need to get much into all these things.