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Shock Absorber

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Samir Joshi, 35-year-old senior vice-president of finance at a very large company in Mumbai, is confused. Sitting back in his chair sipping his steaming cappuccino at Gloria Jeans, a coffee shop in Bandra, he confesses to being all at sea when it comes to where to put his investment rupees. "At one level, I understand all that stuff about global concerns, the India growth story, etc.," he says. "None of it helps me in deciding whether I should go the stock-picking route — and which ones to pick — or the mutual fund route."

Over the past few months, the markets have confounded everybody, from experts to professional investors to amateurs.

"We can't keep it in cash, so putting it in the bank is the other option," says Joshi. But real interest rates on bank deposits are close to zero. Now, his financial advisor  has been talking to him about ETFs or exchange traded funds.

ETFs are considered ‘passive' investment vehicles; basically, they go up when the market does, and down when the market does, and by how much the market does in whichever direction it goes. And thanks to interest in gold as an asset class, ETFs are attracting greater interest.

In March 2011, when Goldman Sachs Asset Management, with over $715-billion in assets under management (AUM), bought Benchmark Asset Management Company, all of whose funds are ETFs, many eyebrows went up. Not because they paid Rs 130 crore for the company, but because Goldman — whose investment philosophy is almost always ‘active' — chose to get into ETFs at all. This is their very first ETF, globally. If Goldman and the likes of Joshi (we changed his name at his request) are thinking about ETFs, should you be too?

Piqued Interest
Much before Goldman Sachs showed its preference for ETFs, there were plenty of players in the Indian markets with offers for ETF-style passive fund management. Mumbai-based India Infoline Asset Management Company (IIFL AMC) launched an ETF as its maiden fund, collecting Rs 33 crore from 15,000 applicants. Motilal Oswal AMC has only ETFs.

Blame the rather uncertain and volatile market conditions that have persisted for several months now for the interest in ETFs. "Poor fund manager performance and the inability to generate alpha (returns) have been the key reasons why players have been launching ETFs in the Indian market," says Rajan Mehta, co-founder of Benchmark AMC, who left the fund by selling his entire stake to Goldman Sachs.

The mutual fund industry — which ETFs are often compared with — is going through tough times. In the first six months of FY2012, the AUM of equity schemes fell 7.5 per cent to Rs 1,54,890 crore from Rs 1,67,620 crore. Market share for equity dropped, from 29 per cent of total AUM in March 2011 to 24 per cent (September).

Performance has been pedestrian, too. At the end of November, 46 of the 394 equity schemes have a net asset value (NAV) below Rs 10 per unit. "Ten years ago you could have made money through active fund management; today it has become difficult as markets are getting more efficient," says Nitin Rakesh, managing director & CEO of Motilal Oswal AMC. "Secondly, the quantum of outperformance (of market benchmarks) has dropped."

ETFs account for just over 1 per cent of the total AUM of the Indian mutual fund industry; the comparable number in the US, Europe and Asia-Pacific is 4-9 per cent. Sanjiv Shah, co-CEO of Goldman Sachs AMC and the co-founder of Benchmark AMC, isn't too worried about the big gap. Between March 2010 and October 2011, there has been an outflow of Rs 6,750 crore in equity funds, compared to an inflow of Rs 5,925 crore in ETFs. Interestingly, of the total inflow into ETF, gold ETFs saw a record inflow of Rs 5,447 crore.

"Index and ETF products are in the nascent stages of development in India," he says. "This is just the beginning of the journey; as investors understand better and see the benefits of investing in ETFs more clearly, there'll be more products and volumes." On 30 September, there were 31 ETFs in India with a total AUM of Rs 10,034 crore (approximately $2 billion). Globally, there are 2,867 ETFs with an AUM of $1.4 trillion. Has that been enough to excite investor interest in ETFs?

Going For Gold
Gold ETFs account for 80 per cent (Rs 8,173 crore) of the ETFs' AUM in India. "Earlier, gold investments preserved wealth," says Keyur Shah, director at the World Gold Council, an industry association. "Today, it creates it." Rakesh of Motilal Oswal couldn't agree more. "Gold has done the Indian market a big favour," he says.

With rising inflation and growing uncertainty in financial markets, gold has become an ideal investment. In return terms, it has been the best performing asset class in the past few years. "On an average, gold has delivered a return of 19-20 per cent every year for the past 10 years," says World Gold Council's Shah.

Thus the rush to launch gold ETFs. The demand for the yellow metal is about 800 tonnes annually; compared to that, demand for gold ETFs is much smaller. That is because investors don't understand ETFs well enough (see box on page 22 for a primer on ETFs). The ETF is not the standard mutual fund we all are familiar with.

The amount of gold held by the ETFs under management is 25 tonnes; small, yes, but it is more than double the 11 tonnes they had in the previous year. The largest gold ETF by tonnage held is the US-based SPDR Gold Shares ETF (Standard & Poor's Depositary Receipts), about 1,200 tonnes.

How are ETFs different from mutual funds? they are designed differently, for one thing. When you buy a mutual fund, you send cash to an asset management company (AMC) or mutual fund company, which issues units (or shares) and uses the cash to buy securities. The market value of the securities is reflected in the net asset value or NAV of the fund. You can redeem units by selling it back to the mutual fund for cash.

An ETF sponsor (unlike the AMC) usually doesn't own the securities, but enters into participation agreements with institutional investors who then provide to create a portfolio; the sponsor issues ‘creation' units against a basket of those securities, usually in multiples of 50,000 shares. Investors buy shares of the ‘creation' units, rather than the underlying stocks.

The market value of ETF shares change as prices of underlying shares change through the day; the NAV of a mutual fund, on the other hand is published only at the end of the day: in other words, it's active rather than passive management. A little like telling your husband to buy the vegetables rather than waiting for him to do it.

Gold ETFs seem a nice way of pandering to our near-insatiable desire for gold; how far can AMCs take that in setting up ETFs?
In other words, will the current heightened interest in gold ETFs be sustainable? A larger question also looms: Will investors be tempted to go beyond gold to other ETFs?

Here Today, Here Tomorrow
Mehta of the erstwhile Benchmark AMC says it's not an investment vehicle that any new entrant AMC can successfully offer. "Unless they can create a niche, the leaders will remain leaders," he says. He likes IIFL's Nifty ETF (an ETF invested in companies that make up the Nifty 50 Index, weighted in the same proportions) for its low costs.

For its new Nifty ETF, IIFL has capped its annual management fee at 0.25 per cent, compared to 0.5-1 per cent that others charge. "That is mainly because IIFL has drawn on its wealth advisory and broking teams to create the ETF team," says an industry insider, who requested anonymity. "Recruiting a new team means higher costs."

Despite the positives, the big problem with ETFs is that they are costly compared to mutual fund units. This is the reason why we have not seen a rush among players to open demat accounts and purchase ETFs. Says Hemant Rustagi, CEO of Wiseinvest, a Mumbai-based mutual fund advisory firm: "Compared to management fee, ETFs look cheaper than mutual funds. But when we include brokerage and demat expenses, ETFs are costlier than mutual funds." Therefore, ETFs are favoured only by investors who have exposure to equity. For pure mutual fund investors, ETFs don't make sense and this has been the precise reason why AMCs are not marketing ETFs.

Although domestically the demand for ETFs is subdued, there is a lot of interest in Indian markets from global ETFs. Funds like Powershares and WisdomTree are setting up offices in India. "Growth in emerging markets like India, China and Brazil make them very attractive," says Naveen Kumar, managing director at INDXX Capital Management, a Delhi-based company that designs global ETFs for Global Emerging Advisors.

The lower volatility and higher liquidity that ETFs offer make it convenient for foreign investors. ETFs have accounted for about 5 per cent of foreign institutional investor (FII) inflows into India; in recent months, however, there have been outflows. The AUM of the 18 India-dedicated ETFs has fallen to roughly $4.6 billion in November from $8 billion at the beginning of January 2011.

"Though the fall in share prices and rupee depreciation have eroded wealth, the biggest reason for the slowdown in inflows is that Indian equities are expensive compared to other BRIC nations," says INDXX Capital Management's Kumar. India trades at a multiple of 14 times forward earnings, compared to 13 times for China, and eight times for Russia and Brazil. But despite the temporary outflows, ETFs are not going away in a hurry. "Once inflation is tamed and other domestic issues impacting growth are sorted out, inflows will resume," says Kumar.

That, many believe, should take about 18-24 months, not a long time in the life of the ETF market. Going by Goldman Sachs AMC's acquisition of Benchmark, it seems the world's most famous investment bank thinks they work in a market like India; and given its long history of success, Goldman should know.


(This story was published in Businessworld Issue Dated 16-01-2012)


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