Exchange Traded Funds: Rise of Passive Investing…Series Begins

This article has first posted here on July, 18 2017. Sharing it again. 

ETF also known as Exchange Traded Funds are on a meteoric rise globally. According to a report by PWC, ETF’s in the US is going to grow to $5.9 trillion by 2021, a whopping 23% cumulative annual growth compared to $1.6 trillion in Europe and $560 billion in Asia. ETF’s are passive investment products which track an index. Exchange Traded Funds are linked to different asset classes like equities and commodities. In the US, S&P 500 would be a broad equity index so an ETF linked to S&P 500 would replicate this index. Replication here means it would track the index. ETF would not outperform the underlying index i.e. S&P 500 but rather deliver similar returns. Let’s understand a few concepts here.  

Alpha means outperforming the underlying index. Mutual funds linked to various underlying indices always try to outperform the benchmark. Equity mutual funds in the US, are linked to equity indices like NASDAQ, S&P 500 etc to share a few examples. An investor pays a fund management fees to the fund house to deliver superior returns compared to the market. If S&P 500 delivers a return of 10% a year, an open-ended mutual fund linked to S&P 500 is expected to return a rate higher than 10%. Hypothetically if the fund returns a 15% return, the fund has an alpha of 5% i.e. the excess return compared to the benchmark index. There are many ways to measure superior return, usually, known as a risk-adjusted return. Risk-Adjusted Returns are the Sharpe Ratio, Treynor Ratio etc. You could refer tutorials to understand the ratios. One key measure to calculate risk-adjusted return is to understand a term known as Beta.

Beta is the covariance of a stock or fund with the benchmark index. When we mention that a fund has a beta of 1, it means that if the benchmark index returns 10%, the fund is expected to give a similar return. The beta of 1.2 means the fund will return 12% when the index returns 10% i.e. 1.2 * 10 while a beta of 0.8 means the fund is expected to return 8% when the underlying index returns 10%.

The higher the beta, the more aggressive the investment strategy of the fund. Funds with the beta greater than 1 are known as active funds since they work on the investment strategy to return higher returns. Funds with the beta of 1 or less than 1 are known as passive funds. ETF’s will always have a beta of 1. ETF’s linked to equity indices like S&P 500, NASDAQ and SENSEX to share a few examples, usually replicated the index in many ways. Usually, the simplest is to have the same portfolio of stocks based on the weighted average of stocks as those that in the benchmark index. There are more advanced ways, based on optimization techniques to replicate the index. However, the funds including ETF’s do suffer from tracking error and this variable needs to be monitored closely.

Over the long-term, few equity mutual funds have beaten the returns of the underlying equity indices. Peter Lynch is one of the few fund managers who consistently outperformed the markets and has written many books on his investment philosophy. Research has shown that very few mutual funds and hedge funds have consistently returned superior returns compared to the market and in turn, take a lot of management fees as a price from investors. Hedge Funds, usually take a fund management fees which is 2% of the asset under management and a percentage of profits. Assume that a hedge fund has 1B under management. A 2% management fees would translate to expenses of 20M per year while hedge funds also charge investors, a percentage of annual returns. Mutual fund only charges management fees apart from administrative costs.

ETF’s have a very low management fee structure and over long-term i.e., more than 3 years deliver better returns than the majority of actively managed equity funds. Other investment options like Angel Investing, Venture Capital, and Private Equity come under alternative investments. They also invest in companies but especially in the case of angel investing and venture capital investments are in unlisted companies and would be looked in a separate article.

ETF’s due to their passive investment strategy, have a low churn ratio compared to active funds i.e. buy and selling of stocks in the portfolio and therefore less administrative and other expenses. ETF’s are very cost-effective compared to actively managed funds and should be included in your equity portfolio. In case you want to take exposure to Gold, ETF’s are a very good way of taking exposure to this asset class. Holding physical gold is not easy since one has to hold a standardized measure, usually in some countries in denominations of 1 Kg with 99.5% purity. Reselling is not easy in physical form and has a carrying cost i.e. locker costs in banks etc. ETF’s provides a cost-effective way of investing in asset classes.

It’s been lonely writing this long so let’s take a friend along who will routinely feature in the article going forward…ALPHA

Alpha would sometime later meet another friend called Beta…Let’s stick to Alpha for the moment…

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