Exchange Traded Funds: Lower expenses is the key
For the purpose of this study we have chosen index funds from both the conventional mutual funds and ETFs segments. We compare Nifty BeES, which is an exchange traded index fund from Benchmark Mutual Fund with regular index funds, having Nifty as their underlying index.
ETFs Vs Index Funds
| |
NAV
(Rs) |
1-Yr
(%) |
3-Yr
(%) |
Since
Incep. (%) |
Std.
Dev. (%) |
Sharpe
Ratio (%) |
Exp.
Ratio (%) |
| Exchange Traded Funds |
| NIFTY BEES |
323.33 |
35.7 |
38.8 |
26.3 |
6.77 |
0.39 |
0.56 |
| Index Funds |
| HDFC INDEX FUND (NIFTY PLAN) |
31.35 |
34.2 |
37.7 |
31.3 |
6.49 |
0.40 |
2.04 |
| PRINCIPAL INDEX FUND |
23.11 |
32.3 |
35.7 |
12.4 |
6.69 |
0.37 |
0.58 |
| FT INDIA INDEX NIFTY (G) |
25.22 |
34.4 |
29.1 |
21.0 |
6.76 |
0.40 |
1.00 |
| S&P CNX NIFTY |
|
34.5 |
38.9 |
|
|
|
|
(Data sourced from Credence Analytics. NAV data as on August 4, 2006. Growth over 1-Yr is compounded annualised.)
Portfolio Strategy
Exchange traded index funds invest in the same stocks that comprise their underlying indices and in the same proportion as well. Akin to conventional index funds, the intention is to mirror the performance of the index as closely as possible. Any change in the constituents of the benchmark index is reflected in the portfolio of the index fund as well.
Performance
Expectedly, the performances of both, ETFs and regular index funds have been rather similar across time frames.
Over 1-Yr period, Nifty BeES with a net asset value (NAV) appreciation of 35.7% surfaces as the best performer among all the funds under consideration and is also successful in outperforming the benchmark index i.e. S&P CNX Nifty (34.5%). However, it is fair to say that the outperformance is unintentional as an index fund attempts to track the underlying index as closely as possible and not consciously outperform it.
A similar picture emerges over the 3-Yr period where Nifty BeES is again the top performer clocking a return of 38.8% CAGR and is successful in matching the returns of the benchmark index (38.9% CAGR). On the other hand, regular index funds like HDFC Index Fund (37.7% CAGR) and Principal Index Fund (35.7% CAGR) have also delivered comparable returns. The only exception is FT India Index Nifty (29.1% CAGR), which fails to track the benchmark index accurately. To the extent an index fund’s returns are off the benchmark index’s returns, the deviation can be attributed to the tracking error.
While comparing the performance of any index fund against its benchmark, it is important to understand that the mandate for index funds is to track or follow the benchmark as closely as possible. Thus, the returns generated by index funds over a period of time should ideally match those of the benchmark index.
Loads and Expenses
This is a major differentiating area between ETFs and regular index funds. While most of the index funds charge entry/exit load from investors for making or redeeming their investments, ETFs do not impose the same. ETFs work a little differently – they provide a platform wherein an investor can directly buy and sell the fund over the stock exchange. Since ETFs are transacted over the stock exchange investors have to pay brokerage to the stockbroker on each leg of the transaction (i.e. at the time of buying and selling). The brokerage on the stock exchange usually hovers around 0.50%. While selling ETFs, investors incur a Statutory Transaction Tax (STT), which is over and above the brokerage.
Since ETFs are traded over the exchange, investors must have a demat account. The annual maintenance for the demat account is Rs 500 (approximately). However, since investors are likely to own stocks in addition to ETFs, the annual demat charges get spread across several investments.
In terms of expenses, ETFs usually have lower expense ratios than regular index funds. As is evident from the table, Nifty BeES has the lowest expense ratio of 0.56%. Among regular index funds Principal Index Fund (0.58%) has the lowest expense ratio, while HDFC Index Fund (2.04%) has the highest one.
Since ETFs are traded over the stock exchange, they can be bought or sold like stocks on a real time basis at a price close to actual NAV (net asset value) of the scheme. This offers investors a unique opportunity as they can enter or exit the fund any time during the trading hours which is not possible with regular index funds; in regular index funds investors can invest or redeem their investments only at end-of-day NAV.
With lower expense ratios and comparable returns, exchange traded index funds score over regular index funds. In our view, investors who want to benefit by aligning their portfolios in line with the index in a cost-effective manner, ETFs are an ideal solution.