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The Inexorable Rise of ETF’s in India

By VCC Staff

  • 31 May 2010

Exchange Traded Funds (ETFs) are investment funds traded on stock exchanges, much like stocks. An ETF holds assets such as stocks or bonds and trades on the stock exchange at approximately the same price as the net asset value of its underlying assets. Most ETFs track relatively well known, liquid large indices such as the Nifty or the S&P500.

Whilst the first Indian ETF was launched in 2001, it is only over the past year that ETFs have come to the fore in India. My discussions with industry participants suggest that pure India-focused ETFs now account for $0.5bn of AUM whereas the Indian equities component of Global Emerging Markets ETFs accounts for another $5.5bn of AUM. Overall, over the past 12 months, around 20% of the net equity flows into the Indian market have come from ETFs. It is unlikely that any other source of fresh equity flows – domestic or foreign - has been able to match ETFs.

As in the West, so in India, the driver of the ETFs’ success has been their low expense ratio compared to actively managed funds. A domestically listed ETF in India will have a typical expense ratio of 1% vs 2.3% for domestically listed mutual funds. Moreover, as the Indian stockmarket matures (and becomes more efficient in weeding out corrupt companies) and as the “alpha” delivered by actively managed funds comes under pressure, the attractions of passive low-cost ETFs which merely track the benchmark could rise.

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However, given that the performance delivered by active funds in India is still markedly superior to that of the index (in most years the leading fund management houses still generate outperformance relative to the index of anywhere between 5-20% points), it is unlikely that simply by mimicking the index, ETFs will go very far. Hence, what is more interesting now is the rise of “Fundamentally Indexed” ETFs.

Rob Arnott, the guru of Fundamental Indexation (hereafter called “FI”), launched his first ETF in the US in 2005. Since then Mr.Arnott has generated a large fan following as other investors have sought to mimic the “best of both worlds” product that FI ETFs seek to offer (the returns of actively managed funds with the costs akin to that of a tracker fund).

If Mr.Arnott’s techniques can be used successfully in India, it will have important ramifications for the Financial Services industry. In this context, it is worth keeping a beady eye on how Motilal Oswal Asset Management’s FI version of the Nifty50 fares. To the best of my knowledge, this is the first launch of an FI product in India and if it succeeds, it will not only produce a host of copycats but could also help boost the wafer thin profit margins of the Indian asset management industry.

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ETFs generally (and FI ETFs in particular if they are successful in India) promise to change the dynamics of a number of different segments of our financial services industry:

         Compared to a conventional fund manager who will pay commissions of 10-30bps, ETFs do not pay any commission. This could lower the institutional equities commission pot of Indian brokers by 10%. Moreover, the market making skills required to offer ETF broking gives the foreign brokers operating in India a distinct advantage over the local brokers. Hence the growing prominence of ETFs could shift market share away from the domestic brokers towards the foreign brokers.

         Given the wafer thin profitability of the Indian asset management sector (EBITDA as a % of AUM is 10-15bps vs 20-30bps elsewhere in Asia), Indian fund houses might have to examine the low cost option of FI ETFs very carefully particularly since they currently spend around 50-55bps on sales & marketing fees for mutual funds. By dramatically cutting down such marketing fees (without increasing the actual cost of running the investment management process), ETFs could help the majority of local fund houses boost their profit margins.

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         ETFs do not buy QIPs or IPOs. If FII equity flows into the Indian market increasingly come via ETFs then that takes away the most obvious route via which investment bankers can sell their issues. This in turn suggests that investment bankers might increasingly have to woo local institutional investors more in order to successfully place new issues. Clearly, there is nothing negative about this – simply a change in the emphasis that investment bankers place on “local versus foreign” distribution of their issues.

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