India’s investment landscape is evolving rapidly, fueled by the growing investable surplus of its upwardly mobile middle class. While earlier Fixed Deposits (FDs) were the favourite instruments for Indian investors (due to guaranteed returns and safety), with inflation rates hovering around 5.48% (November 2024), the real returns on FDs are often low or even negative. Hence, mutual funds provide an attractive alternative. 

However, mutual funds can be traded only once in the day. With a growing number of investors wanting to participate more actively in the ebb and flow of equity markets during the day, Exchange -Traded Funds (ETFs) are gathering traction. An ETF is a pooled investment security that can be bought and sold like an individual stock. It is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.

ETFs track indexes like CNX Nifty or BSE Sensex. When you buy shares/units of an ETF, you are buying shares/units of a portfolio that tracks the yield and return of its native index. It is important to remember that ETFs do not try to outperform the index they track, but they simply replicate it. They don’t try to beat the market, they try to be the market. The trading value of an ETF is based on the net asset value of the underlying stocks that an ETF represents. It is a passive form of investment. 

Benefits of ETFs

Some of the benefits of ETFs in India are:

  • Diversification: ETFs allow investors to diversify their portfolios by investing in a basket of stocks, bonds, or other assets, reducing risk and increasing potential returns. 
  • Flexibility: ETFs can be traded throughout the day, unlike mutual funds, which are traded at the end of the day. This allows investors to quickly respond to market changes. 
  • Transparency: ETFs disclose their holdings daily, enabling investors to make informed decisions. 
  • Cost-effective: ETFs typically have lower fees compared to actively managed mutual funds.

The assets under management (AUM) in ETFs have grown to Rs 8.11 trillion as on July 30, 2024 from Rs 1.88 trillion as on February 29, 2020*. Increased digital penetration has also led to an increase in the acceptance of ETFs with more and more investors opening online trading and demat accounts.

ETFs in India are of different types: 

  • Index ETFs: Track a specific index, such as the Nifty 50 or Sensex, providing broad market exposure. 
  • Sectoral ETFs: Focus on a particular sector, like banking, IT, or pharmaceuticals, allowing investors to tap into growth opportunities. 
  • Gold ETFs: Invest in gold, providing a hedge against inflation and market volatility. 
  • International ETFs: Offer exposure to global markets, enabling investors to diversify their portfolios internationally. 
  • Bond ETFs: Invest in a portfolio of bonds, providing a steady income stream and relatively lower risk.

Recent Initiatives 

Recent initiatives by fund houses have accelerated growth of ETFs. They have been introducing new ETFs that track emerging themes and sectors which may not have received adequate representation in actively managed mutual fund schemes.

The regulatory landscape has been conducive to the growth of ETFs. Securities & Exchange Board of India (SEBI) has already prescribed norms to ensure that ETFs are cost-efficient and that units of ETFs have enough liquidity in the secondary market. Measures such as appointment of market makers and the publishing of i-NAV (indicative net asset value) of the ETF during market hours for equity ETFs have bolstered investors’ confidence.

SEBI has also proposed the introduction of new high-risk products, including inverse ETF. Inverse ETF allows the investor to profit from a decline in the value of the underlying index. This is an effective way of shorting the underlying index.

As India’s consumer spending patterns shift towards non-food discretionary items, there is growing potential for sector-specific ETFs. This trend, coupled with the increasing financial literacy of India’s expanding middle class, suggests that ETFs are poised to play an increasingly important role in the country’s investment landscape. As we move forward, it will be interesting to see how this passive investment format will continue to shape the investment landscape in India, potentially becoming a cornerstone of many investors’ portfolios.

*Source: How ETFs are an effective vehicle for positional trader as well as investors | Economic Times | Aug 18, 2024 

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