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2 New ETFs Enter the Pool of Passively Managed Funds
Jan 20, 2020

A bleak picture of the economy is seen from the rolled-out numbers as the eminent and persistent slowdown continues. Now what has been seen is that the markets, since the measures were announced, have performed well on account of several large caps posting good results, despite the muted consumption. Midcaps have corrected too; but small caps have been beaten down. Despite the correction and the stocks available at attractive valuations, they do not justify the earnings.

Thus, actively managed funds seem like they have taken a backseat for now because investors are losing money and paying higher charges for actively managed funds, which is not going down well with them.

Plus, investors are reluctant to bear any more risk for higher returns, preferring moderate returns in line with the benchmark index instead through passive management, i.e. in Exchange-Traded Funds (EFT).

[Read: Why Are Fund Houses Introducing Passively Managed Funds Now]

What is an ETF?

ETFs are innovative products that provide exposure to an index or a basket of securities or physical gold that trade on the exchange like a single stock. ETFs are an innovation to traditional mutual funds as these provide Investors with a fund that closely tracks the performance of an index / physical gold with the ability to buy/sell on an intra-day basis.

Unlike listed close-ended funds, which trade at substantial premiums or more frequently at discounts to NAV, ETFs are structured in a manner which allows to create new units and redeem outstanding units directly with the fund, thereby ensuring that ETFs trade close to their actual NAVs.

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ETFs are usually passively managed funds, wherein the subscription/redemption of units works on the concept of exchange with underlying securities. In other words, Large Investors/institutions can purchase units by depositing the underlying securities with the Fund/AMC and can redeem by receiving the underlying shares in exchange of units. Units can also be bought and sold directly on the exchange.

ETFs feature all the benefits of indexing such as diversification, low cost, and transparency. As they are listed on the exchange, cost of distribution is much lower, and the reach is wider. These savings in cost are passed on to the investors in the form of lower costs.

Furthermore, the exchange-traded mechanism helps reduce minimal collection, disbursement, and other processing charges. The structure of ETFs is such that it protects long-term investors from inflows, and the outflows for short-term investors. This is because the fund does not bear extra transaction cost when buying/selling due to frequent Subscriptions and Redemptions.

ETFs are highly flexible and can be used as a tool for gaining instant exposure to the equity markets, equitizing cash or for arbitraging between the cash and futures market.

The key benefit of an ETF over traditional open-ended index funds is liquidity and availability of real-time market price on the stock exchange. They can be bought and sold on the exchange at prices that are usually close to the indicative intra-day Net Asset Value (NAV) of the Scheme.

Plus, an ETF does not require active management. The manager of such a fund only buys the stocks of the underlying index and exits a certain stock only when the respective stock exits from the index to be replaced by another one.

The scheme returns may tend to deviate from those of the underlying index resulting in tracking errors. The fund manager does/would monitor the Tracking Error of the Scheme on an on-going basis and will seek to minimize the Tracking Error to the maximum extent possible.

Tracking error with ETFs is likely to be low as compared to a normal Index Fund. Due to the creation/redemption of units through the in-kind mechanism, the fund can keep lesser funds in cash. Also, the time lag between buying/selling units and the underlying shares is much lower.

New entrants...

Two more fund houses too decided to sail the tide with its peers and looking at the need of the hour have also launched exchange-traded fund. ICICI Prudential Mutual Fund has launched ICICI Prudential Midcap 150 ETF and Mirae Asset Mutual Fund launched Mirae Asset Nifty Next 50 ETF.

As mentioned, an ETF tracks an underlying benchmark, each of the ETF tracks a different benchmark. For instance, ICICI Prudential Midcap 150 ETF will be tracking Nifty Midcap 150 Index and Mirae Asset Nifty Next 50 ETF will track/ replicate Nifty Next 50 Total Return Index to generate returns.

As per the respective Scheme Information Document (SID), the objective of each is as follows:

ICICI Prudential Midcap 150 ETF: It is to provide returns before expenses that closely correspond to the total return of the underlying index, subject to tracking errors. However, there can be no assurance or guarantee that the investment objective of the Scheme would be achieved.

Mirae Asset Nifty Next 50 ETF: To generate returns before expenses that commensurate with the performance of the Nifty Next 50 Total Return Index, subject to tracking error. The scheme does not guarantee or assure any returns.

About the benchmark indices:

  1. Nifty Midcap 150 Index:

    NIFTY Midcap 150 represents the next 150 companies (companies ranked 101-250) based on full market capitalisation from NIFTY 500. This index intends to measure the performance of mid-market capitalisation companies. NIFTY Midcap 150 Index is computed using the free-float market capitalization method, wherein the level of the index reflects the total free-float market value of all the stocks in the index relative to particular base market capitalization value.

    Image 1: Sectoral Distribution within the Nifty Midcap 150 Index

    (Source: Nifty 150 Index)

    The top 5 sectoral constituents with maximum weight include Financial services (24.31%), Consumer Goods (16.99%), Industrial manufacturing (9.64%), Energy (9.57%), and Pharma (8.49%). While the top 10 companies included in it are as follows.

  2. Table 1: Top constituents by weightage

    Name of the CompanyWeight in the index (%)
    Info Edge (India) Ltd1.95%
    Federal Bank Ltd1.94%
    City Union Bank Ltd.1.90%
    RBL Bank Ltd1.80%
    Voltas Ltd1.69%
    Indraprastha Gas Ltd1.65%
    AU Small Finance Bank Ltd1.61%
    Apollo Hospitals Enterprise Ltd1.53%
    MRF Ltd.1.52%
    Tata Global Beverages Ltd.1.48%
    (Source: Nifty 150 Index fact sheet)
  3. Nifty Next 50 Total Return Index:

    The NIFTY Next50 is a diversified 50 stock index accounting for 14 sectors of the economy. The NIFTY Next 50 Index represents 50 companies from NIFTY 100 after excluding the NIFTY 50 companies, which is about 10% of the free float market capitalization of the stocks listed on NSE as on March 29, 2019.

    The method also considers constituent changes in the index and importantly corporate actions such as stock splits, rights, etc. without affecting the index value. Stocks are selected based on their float adjusted market capitalization, liquidity, and other factors. It has a base period of November 4, 1996 with a base index value of 1000.

    To be considered for inclusion in NIFTY Next 50 index, companies must form part of NIFTY 100, but should not be forming part of the NIFTY 50. Eligibility criteria for newly listed security are checked based on the data for a three-month period instead of a six-month period.

    Image 2: Sectoral Distribution within the Nifty Next 50 Total Return Index

    (Source: Nifty Next 50 Index)

    The top 5 sectoral constituents with maximum weight include Financial Services (31.81%), Consumer Goods (23.17%), Pharma (11.82%), Cement & Cement Products (6.88%), and Energy (5.8%). While the top 10 companies included in it are as follows.

    Table 2: Top constituents by weightage

    Name of the CompanyWeight in the index (%)
    HDFC Life Insurance Company Ltd.4.69%
    SBI Life Insurance Company Ltd4.55%
    ICICI Lombard General Insurance Company Ltd3.55%
    Shree Cement Ltd.3.48%
    Dabur India Ltd.3.31%
    Godrej Consumer Products Ltd.3.31%
    Divi's Laboratories Ltd3.01%
    Bandhan Bank Ltd.2.72%
    Pidilite Industries Ltd.2.70%
    Avenue Supermarts Ltd.2.65%
    (Source: Nifty 50 Index fact sheet)

Benefits of ETFs

ETFs have several advantages over traditional open- ended Index Funds as they can be bought and sold on the exchange at prices that are usually close to the actual intra-day NAV of the Scheme.

  1. Can be easily bought / sold like any other stock on the exchange through terminals spread across the country.
  2. Can be bought/sold anytime during market hours at prices that are expected to be close to actual NAV of the schemes. Thus, investor invests at real-time prices as opposed to end of day prices.
  3. No separate form filling for buying / selling units. It is just a phone call to your broker or a click on the net.
  4. Ability to put limit orders.
  5. The minimum investment for an ETF is one unit.
  6. Protects long-term investors from the inflows and outflows of short-term investors.
  7. Flexible as it can be used as a tool for gaining instant exposure to the respective equity/gold markets, equitising cash, hedging or for arbitraging between the cash and futures market.
  8. Helps in increasing liquidity of the underlying cash market.
  9. Aids low-cost arbitrage between futures and cash market.
  10. An investor can get a consolidated view of his investments without adding too many different account statements as the Units issued would be in demat form.

Asset allocation and risk...

As per the mandate, both the schemes, ICICI Prudential Midcap 150 ETF and Mirae Asset Nifty Next 50 ETF will invest a minimum 95% of total assets of the scheme in securities of their respective tracking index.

As ETFs or exchange-traded funds both comprise of stocks that will replicate the composition of its benchmark index to provide the investor to hold a diversified portfolio of well-known companies and on a real-time basis at lower costs.

However, since the schemes are purely equity-based, the risk involved is extremely high concentration and the fund manager will not do any analysis and will track the index closely. So, only investors who have the stomach for high risk and an investment time horizon of at least 5 years should consider them.

[Read: Why Comparing Returns to Risk Is More Meaningful!]

What Are the Investment Strategies?

  1. ICICI Prudential Midcap 150 ETF

    The corpus of the Scheme will be invested predominantly in stocks constituting the underlying index in the same proportion as in the Index and endeavour to track the benchmark index. A very small portion (0-5% of the Net Assets) of the fund may be kept liquid to meet the liquidity and expense requirements. The fund may also use various derivatives and hedging instruments from time to time, as would be available and permitted by SEBI, to protect the value of the portfolio and enhance unitholders 'interest.

    The performance of the Scheme may not be commensurate with the performance of the underlying index on any given day or over any given period. Such variations are commonly referred to as the tracking error. The Scheme intends to maintain a low tracking error by closely aligning the portfolio in line with the index. The stocks comprising the underlying index are periodically reviewed by the Index Service Provider. A stock may be dropped, or new securities may be included as a constituent of the index. In such an event, the Fund will endeavour to reallocate its portfolio, but the available investment/ disinvestment opportunities may not permit precise mirroring of the underlying index immediately.

    Similarly, in the event of a constituent stock being demerged/merged/delisted from the exchange or due to a major corporate action in a constituent stock, the fund may have to reallocate the portfolio and seek to minimize the variation from the index. In such events, it may be more prudent for the fund to take exposure through derivatives of the index itself or its constituent stocks in order to minimize the long-term tracking error.

  2. Mirae Asset Nifty Next 50 ETF

    The NIFTY NEXT 50 ETF will be managed passively with investments in stocks in a proportion that matches as close as possible to the weights of these stocks in Nifty Next 50 Index. The investment strategy would revolve around reducing the tracking error to the least possible point through regular rebalancing of the portfolio, taking into consideration the change in weights of stocks in the Index as well as the incremental collections/redemptions in the Scheme. A part of the funds may be invested in debt and money market instruments to meet the liquidity requirements.

    Fund managers:

    Mr Kayzad Eghlim is the designated fund manager of ICICI Prudential Nifty Midcap 150 ETF

    Mr Kayzad has earned a B.Com and M.Com as well as a Masters in Business Administration degree to his credit. He has been associated with ICICI AMC since 2008. Prior to that, he has been associated with IDFC Investment Advisors Ltd, Prime Securities, and Canbank Mutual Fund.

    Some of the other schemes Mr Enghlim has managed in the past are ICICI Prudential Nifty Index Fund, ICICI Prudential Nifty Next 50 Index Fund, ICICI Prudential Sensex ETF, ICICI Prudential Equity- Arbitrage Fund - Equity Portion, ICICI Prudential Nifty ETF, ICICI Prudential Nifty 100 ETF, and ICICI Prudential NV20 ETF, ICICI Prudential Midcap Select ETF.

    Mirae Nifty Next 50 ETF will be managed by Ms Bharti Sawant. She is a BCom Graduate, with a CFA degree and has done ICFAI.

    Ms Sawant has professional experience of more than 12 years and her primary responsibility includes Investment Analysis & Fund Management. She has been associated with the Mirae Asset Management Company as an Investment Analyst since September 3, 2013. She was previously associated with Sushil Finance Securities Pvt. Ltd., Latin Manharlal Securities Pvt. Ltd., Kabu Shares & Stocking Pvt. Ltd. for Financial Analysis and Research.

Additional Information:

  • New Fund Offer opening date:
    1. ICICI Prudential Midcap 150 ETF opens on January 15, 2020
    2. Mirae Asset Nifty Next 50 ETF opens on January 13, 2020
  • New Fund Offer Closing date
    1. ICICI Prudential Midcap 150 ETF closes on January 20, 2020
    2. Mirae Asset Nifty Next 50 ETF closes on January 21,2020
  • Min. Investment: Rs 5,000 and of Re 1 thereafter allowed for investment for both the schemes
  • Exit load: No exit load will be levied for both the schemes
  • Plans: No plans options offered for both the schemes.

Outlook for ETFs.

In India, ETFs are slowly catching up with the global trend of investing in mutual funds. With most of the actively managed funds having underperformed in the last few years, Index funds and Index ETFs are slowly catching the fancy of investors. Fund houses are making an attempt to provide more options for investors to choose from.

ETFs could be beneficial for investors who find it difficult to analyse and pick stocks for their portfolio. Globally, they have gained wider acceptance as a financial instrument as they attempt to replicate the underlying index and provide diversification in the endeavour to clock returns closely corresponding to the underlying index. Moreover, by being listed and trading on the exchange they can be bought and sold real time, subject to the availability of buyers and sellers for units.

In the current scenario, there are several macroeconomic and geopolitical factors at play that will affect the performance of the Nifty Midcap 150 Index and Nifty Next 50 Total Return Index. Being passively managed, the fund managers will not conduct any analysis on the stocks and will only try to mirror the index. Hence the performance of the funds will be solely and closely linked to how the respective index perform.

[Read: Skip NFOs, Instead Consider Building A Strategic Mutual Fund Portfolio]

Editor's note: The last few years have not been among the best for equity mutual funds. While most funds have underperformed or are struggling to match the returns of the benchmark, there are few funds that have the potential to constantly generate alpha for its investors. And we have identified five such high alpha generating funds, in our latest report 'The Alpha Funds Report 2020'. Do not miss our latest research finding. Get your access to this exclusive report, right here!

Author: Aditi Murkute

This article first appeared on PersonalFN here.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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