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The ETF advantage

A buoyant stock market makes exchange traded funds an attractive investment option that combines the relative safety of MFs and the freedom and flexibility of investing directly in stocks.

twitter-logoManu Kaushik | Print Edition: March 7, 2010

For most investors, mutual funds (MFs) are the preferred route for investment in equities. They find it prudent to leave the hassles of investing in stocks to fund managers, who have the requisite expertise and infrastructure at their disposal, rather than get into equities on their own, which can take a huge toll of their time and, in case of any misjudgment, their investments. But the almost runaway rise in the stock market indices since April last year (62 per cent in Sensex and 56.6 per cent in Nifty), which investors and experts alike see continuing unabated over the long term, has brought the focus back on a less celebrated but very useful investment product that combines the best of both worlds—the relative safety of MFs and the freedom and flexibility of investing directly in stocks: ETFs or exchange traded funds.

Rs 1,00,000# INVESTED A YEAR AGO IN THE FOLLOWING HAS TODAY BECOME...

  • Diversified Equity Funds^: Rs 1,90,400*
  • ETFs^: Rs 1,89,360*
  • Index Funds^: Rs 1,71,170*
  • Reliance Industries: Rs 1,58,450*

#As on February 5, 2009
*As on February 4, 2010
^The returns are average of top performing diversified equity, index and exchange traded funds

—Source: BT Research

So, what exactly are ETFs? They are hybrid products with features of both a mutual fund and exchange listed securities. An ETF represents a basket of stocks that forms an index such as Nifty 50 or Sensex 30. ETFs are traded on the stock exchange and can be bought and sold directly during trading hours just like individual stocks. Their unit prices are derived as a proportion, usually 1/10 or sometimes 1/100, of the index they track.

Consider this: Rs 1,00,000 invested a year ago in a top ETF has given returns of close to 90 per cent, which is second to only the average yield of the top performing diversified equity funds and better than the average return of the best performing index funds and an outperforming stock like Reliance Industries (see graph on the opposite page). Says Gaurav Mashruwala, Director, ACE Financial Advisory Services: "In the last one year, ETFs have performed well due to the sharp run-up in the stock market. If you're trying to get market returns, then ETFs still appear to be an attractive option for investors with a long-term horizon."

One of the big selling points for ETFs is that they minimise risk and help investors diversify their portfolio. Investing through ETFs ensures that the downside risk is defined, i.e. if the market falls by, say 10 per cent, it is likely that the ETF will also fall by the same proportion. Analysts believe that most investors don't have the expertise to take calculated risks while building a stock portfolio. The problem gets worse when they get busy and forget to even look at the portfolio they have built so carefully. "ETFs, on the other hand, are automatically diversified equities. They greatly reduce the risk because there is minimal exposure to any particular stock," says Rajan Mehta, Executive Director, Benchmark Mutual Fund.

Another advantage of ETFs is that they never seek to beat the market. Instead, their goal is to move in tandem with a particular index. To put it differently, many ETFs strive for a beta of 1 relative to the underlying market index. A beta of 1 means that the ETFs are neither more nor less volatile or risky than the wider market.

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