New indices will offer more investment choices

Exchange Traded Funds (ETFs) are always considered a safe bet, especially in a volatile equity market like the one we are seeing now. Now there are enhancements coming to traditional ETFs that will allow investors more options. Such products are just taking off in India. But going forward there is tremendous scope – both for returns for the investor and for finding hidden jewels within equity markets. DNA Money spoke to fund managers and investment experts to understand what these new age ETF products are and how they can help you.

As markets and investors mature, the need for variety grows, said Koel Ghosh, business head, South Asia, S&P Dow Jones Indices & Asia Index. "Factor-based strategies take some key factors (like volatility, momentum etc) and convert them to rules, whereby those rules govern the selection of constituents. The different (tracking) concepts evolve to focus on providing an alternative basket and strategy thereby,'' she explained.

How useful are ETFs

An ETF is a tradable security that tracks a particular index, say Sensex or Nifty. The very nature of ETFs helps in diversifying the investment portfolio and also offer investing at a low cost compared to actively managed funds. "ETFs mostly mirror indices which they track and best and worst performer can be tracked looking at the underlying index and comparing it with the benchmark indices," said Tarun Birani Founder and CEO of TBNG Capital Advisors.

What the new indices and ETFs offer

This new generation of ETFs differ from historical ETF's that traditionally have been quite simple and sector specific.                                                 

"The prime driver of these factor-based (that is, volatility, momentum etc) ETFs is to improve the diversification of index and investment options by playing with factors that have proven to reward investors over the years," said Radhika Gupta, CEO Edelweiss AMC.

The new series of indices and the ETFs that invest in them, seek to trawl unknown aspects of the investment universe. To illustrate with an example, in the S&P BSE Low Volatility Index, the top 30 stocks that are least volatile form the index. This index will have a different behavior to a standard market-cap weighted index, as the stocks are not weighted by market capitalisation, but based on volatility.

The new indices look at (or chart) other aspects of investment like volatility, quality (based on return on equity, accruals ratio, or financial leverage ratio), value (based on book value-to-price, earnings-to-price, or sales-to-price), among others, as opposed to the more traditional benchmark of market capitilisation. "The resulting index is not market-cap weighted, rather it is weighted by the specific factor," said Ghosh.

Some of the new generation of ETFs that will be launched, based on new investment faucets will include PSU ETFs, gold ETFs, smart beta ETFs, banking ETFs, NIFTY Alpha Low-Volatility 30, NIFTY Quality Low-Volatility 30, NIFTY Alpha Quality Low-Volatility 30 and NIFTY Alpha Quality Value Low-Volatility 30.

"In the case of the smart beta ETFs (new generation of ETFs) the stock selection or weightages are not market driven," said Chintan Haria, head - product development & strategy, ICICI Prudential AMC. This means the largest companies do not necessarily have the largest weights in the index. "That's why smart beta ETFs have a scope to perform better than traditional ETFs," he added.

How are they better

Traditional ETFs, usually track larger sectors, such as banking. This is a concern because such ETFs focus on market cap, rather than specific factors. Remember, in 2000, IT (infotech) had a large weightage in the broader market indices and the 2001-03 correction saw the sector bringing down the indices. Today, too, banking and allied sectors (BFSI) have a 40% share of the Sensex and any negativity in this sector is bound to affect markets, indices and (established) ETFs as a whole.

"However, when it comes to smart beta indices, it covers different sectors and can also have a sector/weightage cap," said Haria.

"The factor based ETFs use well established stock-specific factors that are used in active investment and combine that with rules-based framework of passive investment," said Gupta. Using these tactics factor-based index strategies combine benefits of both active and passive investment styles and tend to deliver risk premium in the long run in a transparent, rule-based and cost-effective manner.

"The last one and three-year returns of the factor-based indices have been better than the frontline and broader indices," said Gupta.

Such factor based ETFs can easily be bought by retail investors. "ETFs are essentially index funds that are listed and traded on exchanges like stocks and can be bought and sold anytime during the trading day," said Gupta.

The factor based ETFs allow investors to get into markets with a lower investment outlay. "Factor based ETFs give retail investors an opportunity to participate in the growth of equities through the purchase of small units,'' said Haria. One can even buy just one single unit of an ETF.

Equity-oriented ETFs have the same taxation as equity investments. If held for less than 12 months, they attract Short-Term Capital Gains tax of 15% , and if held for more than 12 months then Long-Term Capital Gains tax is 10%.

The factors that affect the bourses like sliding rupee, rising crude etc will impact factor based ETFs as well. "In general, factor ETFs do what they say they do and they do it well. But to say that there are no risks is to ignore reality," said Gupta, noting that ETFs share the same risk that of broad indices.

However, one can use strategy to choose one's factor ETF, just as you would with buying a particular stock. To cite the example of the sliding rupee's effect on the bourses and on the ETFs. An export oriented ETF will certainly benefit from the depreciating rupee. But the same sliding rupee would affect crude prices and thus sectors like banking will be affected.

"So stock selection, sector caps, and weightages play a key role in the returns that a factor based ETF will give," said Haria.

"Look at your risk tolerance and goals," said Birani. Thus, investors looking at bluechip equity investment can look at Nifty or Sensex ETF, whereas investors ready to take a higher risk can look at the Nifty Next 50 or Junior Nifty structures, Birani advices.

NEW STRATEGIES

• Factors based indices and ETFs look at volatility, quality (based on return on equity, accruals ratio, or financial leverage ratio), value (based on book value-to-price, earnings-to-price, or sales-to-price).
   
• Factor-based index strategies combine benefits of both active and passive investment styles and tend to deliver risk premium in the long run in a transparent, rule-based and cost-effective manner.