Lower commissions, inadequate hedging options and lack of Authorised Participant interest remain areas on concern, finds team Cafemutual
Although exchange traded funds (ETFs) are slowly beginning to gain popularity in the Indian markets with more and more fund houses rushing to launch passive funds, there are few takers for them.
One of the factors attributed for the tepid growth of ETFs is lack of incentives for distributors. Typically ETFs are low cost products which can be easily bought and sold through the exchanges. Thus the distribution cost is eliminated in this process. As ETFs are akin to stocks, which can be traded on a real time basis, there is no assurance that investors will remain invested for a long period. Thus ETF products do not offer any trail commission to distributors unlike equity funds. Only an upfront commission in the range of 25 to 50 basis points is paid for fresh sales. The brokerage house charges a percentage of fees from investors on a per transaction basis.
“As a business model ETFs are not designed to offer commission to distributors. It does deter some distributors from recommending ETFs to their clients,” said Rajan Mehta Executive Director, Benchmark Mutual Fund.
“The entire ETF industry is pretty small and nascent in India. The brokerage structure is not very lucrative. Distributors generally shy away from selling ETFs. Until there is a comprehensive change in the incentive structure for distributors it would be difficult to penetrate ETFs further,” said Rakesh Goyal, Senior Vice President, Bonanza Portfolio Ltd.
“Distributors usually thrust upon an actively managed fund to investors. Investors are shown a chart that the returns are fabulous; it has beaten the Sensex, Nifty, etc. But if you see worldwide it’s better to track the index. So, it’s still some time away before ETFs become popular,” said Jimmy Patel, CEO, Quantum Mutual Fund.
Apart from low commissions, experts point out that lack of business opportunity for authorised participants and absence of hedging options are also a cause of concern. Authorised Participants act as market makers for ETFs. Fund houses buy shares of the underlying index from APs, large investors and institutions and in return issue them ETF units called ‘Creation Unit’. “The AP has to allocate capital to undertake this activity. There is opportunity loss in this. Liquidity and popularity of the product also determine the earnings potential,” adds Mr Patel.
The APs shield themselves from this loss by incorporating these costs in their bid/offer spread (difference between the bid price and the offer price) in the market.
Mr. Patel says that the underlying index in an ETF should be liquid enough to enable the AP to buy or sell the index stocks while creating or liquidating the units. Besides, he also points out that lack of hedging options make ETFs dicey in the event of a loss.
“No adequate hedging mechanisms are available to safeguard against losses while holding on to ETF units. There is no ETF linked derivatives. Costs of creation/liquidity are treated as corporate action by the depositories which involve costs, and if not borne by the Mutual Fund/AMC further reduces the margin of the AP,” adds Mr. Patel.
“ETFs may not have derivative themselves but the indices they follow have derivatives and hence in such ETFs hedging is possible. Like Nifty BeES does not have derivatives but futures and options in Nifty Index are available and it can be used,” adds Mr. Mehta.
With more than twenty ETFs listed on the stock exchanges and many more in the pipeline, fund houses remain upbeat about the potential of ETFs. “ETF future is bright both in India and globally. This is mainly due to its unparalleled transparency and cost efficiency. We are already witnessing decent growth in ETF AUMs in India. Many new ETFs are on drawing board. Awareness is spreading and number investors are increasing. With evolution of fee based advice, ETFs will grow even faster,” adds Mr. Mehta.
According to AMFI data, the market share of other ETFs which track the equity indices was just Rs 1,610 crore or 0.24% of the total AUM of the industry while that of Gold ETF was Rs 2,849 crore or 0.43% as on September 2010.
Since the last one year, the number of ETF folios (other than gold) has gone up marginally from 24,985 folios in March 2009 to 36,898 folios in March 2010. On the other hand, Gold ETFs are gaining wider acceptance among investors. Gold ETFs saw their folios jump by 64% from 89,429 folios in March 2009 to 1, 47,047 folios as on March 2010.