Exchange Traded Funds (ETFs): Rising popularity,

but it is too much hype too soon?

Domestic ETF industry grew at a stellar pace on account of lower base and
largely driven by EPFO investment
• Global ETF market grew at a health ~18% CAGR over the last decade to reach $ 5 trillion driven by
passive industry in United States (with a market share of 71%), followed by Europe (16%), Asia
Pacific (11%) and Rest of the world (2%)
• Domestic ETF industry has registered a tremendous growth ~49% CAGR over last 10 years to reach
Rs. 1.06 tn in February 2019 amid a lower base.
• Domestic ETF industry witnessed 10 fold jump from 2014 to 2018 with major contribution from
Employees’ Provident Fund Organization (EPFO) as it stepped up its annual investment of
investible deposits from 5% in 2015 to 15% currently into equity markets through ETF route.
• Domestic ETF market is lop sided towards Equity ETFs (~94%), followed by Gold (4%) and Debt
ETFs (2%). Institutional investors dominate the ETF market with ~93% market share.
• ETF industry is currently low on penetration as the ETF assets contribute only 5% to the total
Mutual Fund industry AUM.
• NIFTY Indices currently have ~78% market share by assets under management (AUM) with NIFTY
50 being the most widely tracked underlying index and most ETFs pegged to it, with a market
share of ~53% to the Equity ETF AUM.
• However, industry is gripped by illiquidity in certain space, institutional investor driven market,
dearth of investment options and lack of investor awareness

Exhibit 1: Domestic ETF assets grew at the staggering rate over the last 10 years driven by EPFO inflows
1,20,000

Rs. 1,04,584 Cr
1,00,000

80,000

67,658
AUM in Rs Cr

60,000

40,000
32,807

20,000 15,178
10,025 11,040
7,641 6,298 7,299
5,513 3,722
2,833 1,935 1,585
29 277
-
Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18
ETFs - combine the positives of Mutual funds and Stocks, however, major
shortcomings persist
ETFs are passive vehicles that combine the best of both worlds: mutual funds and stocks. The ETFs are
well diversified, low on volatility, have low expense ratios and can be traded like stocks on an
exchange. Fees play a crucial role as ETFs seem to benefit over active funds after netting off for
management fees.

However, the passive instruments have significant shortcomings over stocks and mutual funds.
Domestic ETF market is relatively illiquid with low volumes and average daily turnover. The market is
dominated by institutional investors with ~93% market share. There are just 67 listed ETFs largely
concentrated in Large caps as Mid, Multi cap, Strategy/Sector/Thematic categories get a smaller share
of the pie. The category has dearth of investment options other than Large cap category hence for a
prudent investor desirous of diversifying his portfolio over a range of asset categories and classes the
options are limited. Exhibit 2 below captures the benefits and shortcomings of ETFs.
Exhibit 2: Benefits and shortcomings of ETFs
Benefits
Parameter Stocks Mutual Funds ETFs
Exposure Narrow Broad Broad
Volatility High Low Low
Cost of maintenance Low High Low
Price Market Rates NAV at EOD Market Rates
Shortcomings
Liquidity High High Low to Medium
Investment Options High High Low
(Large stock (Multiple schemes (Few listed ETFs, fewer options
universe) and categories) among Mid, Multi cap,
Strategy/Sector/Thematic categories)

Shrinking alphas in active funds helping shift towards passive styles, however,
fund manager’s skills help active funds comfortably outperform benchmarks
in long term
Global equity markets have witnessed a gradual shift from active investment style to passive strategies
as alphas have shrunk. Studies conducted domestically have shown that over shorter investment
horizons actively managed large cap equity funds in India underperformed their large cap benchmarks.
Reform initiatives by Securities and Exchange Board of India (SEBI) like ‘Rationalization and
categorization of mutual funds’ and ‘Benchmarking to Total Returns Index (TRI)’ have made it difficult
for fund managers to generate significant alpha over the benchmarks.
 Exhibit 3: Best performing large cap schemes on the basis of 5 years investment horizon
CAGR Returns (%)
Large Cap Schemes AUM(in Rs Cr)
Sr No 6 Months 1 Year 2 Years 3 Years 5 Years 7 Years 10 Years
1 Reliance Large Cap Fund(G) 10,900 9.04 14.23 13.59 17.66 16.99 16.57 17.53
2 SBI BlueChip Fund-Reg(G) 19,565 6.96 5.32 8.56 12.71 15.50 16.42 17.47
3 DSP Focus Fund-Reg(G) 2,169 8.76 5.45 6.71 12.80 15.16 13.50 -
4 HDFC Top 100 Fund(G) 14,728 9.70 17.11 12.19 18.54 14.72 14.36 18.19
5 Axis Bluechip Fund(G) 3,170 6.59 14.49 16.48 16.48 14.36 15.81 -
6 ICICI Pru Bluechip Fund(G) 19,132 4.15 9.16 10.97 16.16 14.33 14.91 18.55
7 Aditya Birla SL Frontline Equity Fund(G) 20,290 6.88 8.34 8.76 14.12 14.32 15.78 18.24
8 Aditya Birla SL Focused Equity Fund(G) 3,909 6.35 8.26 8.25 13.98 14.28 15.55 17.56
9 Motilal Oswal Focused 25 Fund-Reg(G) 1,058 4.45 4.42 7.93 14.15 14.19 - -
10 BNP Paribas Large Cap Fund(G) 768 7.29 7.83 8.63 11.25 14.06 14.24 16.05
Benchmark Index - Large Cap (NIFTY 100) 6.43 13.92 13.33 16.91 13.85 14.30 16.48
*Performance as on March 29,2019. **Schemes sorted based on 5 year CAGR returns
Note: CAGR returns are considered for investment horizon more than 1 year. Hygiene factor of AUM > Rs. 400 Cr is applied for all schemes

However, fund management skills tend to play a crucial role as actively managed funds tend to
comfortably outperform benchmarks over longer investment horizons. In large cap funds category,
schemes have outperformed their benchmark index (NIFTY 100) over greater than 5 years investment
horizon. Best performing funds have delivered a sizeable alpha over benchmark, in some cases as high
as >300 bps underlining importance of fund managers’ skills in beating the market.
Exhibit 4: Best performing Multi-cap schemes on the basis of 5 years investment horizon
CAGR Returns (%)
Sr No Multi cap Scheme
AUM 6 Months 1 Year 2 Years 3 Years 5 Years 7 Years 10 Years
1 L&T India Value Fund-Reg(G) 7,700 4.32 0.52 6.66 15.61 21.17 19.67 -
2 Reliance Focused Equity Fund(G) 4,077 9.10 3.76 8.03 16.68 20.54 19.16 20.93
3 Invesco India Contra Fund(G) 2,726 5.98 8.55 13.38 17.79 19.65 17.92 20.95
4 Tata Equity P/E Fund(G) 4,856 3.85 0.76 7.91 19.02 19.39 16.86 20.28
5 Franklin India Focused Equity Fund(G) 7,190 11.16 9.95 9.74 15.49 19.29 19.54 22.07
6 SBI Focused Equity Fund-Reg(G) 3,167 10.19 7.85 15.75 16.65 18.97 18.10 25.96
7 Kotak Standard Multicap Fund(G) 20,608 8.43 11.47 11.54 17.90 18.77 18.28 -
8 Aditya Birla SL Pure Value Fund(G) 3,996 0.53 -13.16 1.40 12.11 18.73 18.67 21.62
9 SBI Magnum Multicap Fund-Reg(G) 5,967 7.62 5.89 10.17 15.18 18.66 17.15 17.29
10 Mirae Asset India Equity Fund-Reg(G) 9,296 7.74 14.14 13.68 18.92 18.35 18.22 22.65
Benchmark Index – Multicap (NIFTY 500) 6.43 9.70 11.65 16.63 14.49 14.27 16.53
*Performance as on March 29,2019. **Schemes sorted based on 5 year CAGR returns
Note: CAGR returns are considered for investment horizon more than 1 year. Hygiene factor of AUM > Rs. 400 Cr is applied for all schemes

In Mid cap and Multi cap funds category particularly there are very few options to choose from. For
instance, there is just 1 listed ETF domestically ‘ICICI Pru S&P BSE 500 ETF’. Here, mutual funds tend
to typically score over passive vehicles as best schemes have generated commendable alpha over their
category benchmark NIFTY 500. Best performing scheme ‘L&T India Value Fund’ managed to deliver
an alpha of ~660 over NIFTY 500 on 5 year investment horizon.
Conclusion
ETFs, passive investment vehicles, seek to mirror the rule-based, market relevant underlying indices
and hence are designed to replicate the returns of the benchmarks. ETFs offer certain attractive
features like lower management fees, low volatility and diversified portfolio. However, they suffer
from disadvantages over active fund management such as illiquidity and lesser options in across
categories such as Midcap, Multi cap and strategy/sector/thematic. Actively managed schemes tend
to outperform, benchmarks as fund management skills tend to be the determining factor in generating
long term alpha every prudent investor is desirous of. Investor inclined towards adopting ‘Meet the
market first and then beat it’ strategy can opt for passive investment style (such as Index funds and
ETFs) along with active funds in their portfolios.

(The article is written by author Shulin V K Satoskar, purely from analytical research point of view)