Remember Chuck Noland, the FedEx executive, who was cast away on a desolate island by a plane crash? Through his every failed attempt to rescue himself he learned to make his raft stronger. He was lucky at last when a ship spotted him in the sea, but you may not be so in a sea of 5,000 companies listed on the Bombay Stock Exchange. So, set your raft right lest you take a plunge.

In your first tryst with the rough waves of the equity market, your best raft could be the Exchange Traded Funds (ETFs) because they replicate an index and its holdings and generate returns similar to the underlying index.

“The optimal approach for an investor new to the equity markets is to approach these waters (equity investing) via Exchange Traded Funds as a stepping stone,” says Chintan Haria, who leads the Product Development and Strategy wings at ICICI Prudential AMC.

A Nifty 50 Index ETF holds all the Nifty 50 stocks in the same proportion as the index and thereby mirrors the returns generated by the index. By investing in an index, one need not worry about the research and analysis. ETFs are diversified into many companies and hence the risk of losing capital reduces compared to investing directly in companies.

It is the insight that makes all the difference between direct investing and investing through ETFs. “Direct investing into equities requires an investor to have the resources and expertise to do a fundamental analysis of the stock(s) they are looking to buy and also continue to evaluate these,” points out Kaustubh Belapurkar, Director Manager Research, Morningstar Investment Adviser India.

Buying an ETF, on the contrary, lets you invest in a diversified portfolio of stocks for small investment amounts, which is hard to do when you are trying to buy a basket of individual stocks. Unless the investor has a reasonable understanding to analyse the fundamentals of a stock as well as ready to commit time, it may be better to make equity investments through ETFs or equity funds.

“Both direct investing and ETF options have their pros and cons, and the selection of one over the other depends on the investor’s risk appetite, investment objective and, above everything, investing experience,” says Prateek Jain, Co-Founder of Winvesta.

Diversification is a key principle in sound long-term investing. ETFs are vehicles that allow retail investors to achieve diversification in an efficient manner.

While market-savvy investors pick multiple stocks (besides other asset classes) to custom-build a diversified portfolio, for the average retail investor, that strategy is time-consuming and could even be intimidating. Investing in ETFs is relatively easier and safer.

“ETFs offer low fund management expenses vis-à-vis direct investing into equities where you have costs like brokerage, GST, etc,” points out S Ravi, former chairman of the Bombay Stock Exchange (BSE).

Data from 2020 throws out the importance of ETFs in the Indian investing scene. While new demat investors grew by about 17 per cent in the last six months, the number of folios in Index/ETF schemes grew at a faster clip, indicating that investors are getting familiar with and are investing more through the ETF route. Figures speak for themselves: 37 per cent growth in Index Funds, 44 per cent in Gold ETFs and 52 per cent growth in non-Gold ETFs in the last six months.

One would, however, wonder if the swing would sustain after the Covid crisis wanes away. “The acceptance of ETF as an investment product has been on the rise over the past five years with the ETF assets – a sum of equity and debt – crossing the Rs 2-lakh-crore mark,” says Haria. This is in line with the trend seen in the US where the assets of passive funds like ETFs have become larger than active fund assets as investors have begun appreciating the potential of ETFs.  “The shift towards ETFs is not very new in India. It merely got accelerated due to the pandemic,” says Jain. As markets mature and information asymmetry, or unevenness of information between investors, declines, it gets harder for active investment strategies to beat the benchmark consistently. “Investors thus move towards passive investments like ETFs. The same phenomenon is now unfolding in India.”

In the US, the assets under management (AUM) under ETFs grew fivefold in the last decade. The overall market cap only doubled in the same period. Passive investing through ETFs now makes almost 50 per cent of all assets for US stock-based funds. This ratio was at 25 per cent in 2010.

Despite the pandemic, investors into ETFs got liquidity and price transparency in their investments, notes Ravi.

Through ETFs, an investor can take exposure to indices such as S&P BSE Sensex 30 or Nifty 50 or BSE500, Nifty100 Low Vol 30, or Private Bank Index at a fraction of the cost, all the while enjoying the flexibility to buy and sell as and when required. “We believe the wide array of choices, ease of transaction, and low-cost structure have aided in attracting new-age investors to ETFs,” says Haria.

The taxation aspects for both direct investing and ETF investing are broadly similar. “The tax treatments for investing directly in stocks and investing in equity ETFs or mutual funds are the same,” Belapurkar says.

“The greatest enemies of equity investors are expenses and emotions,” said ace investor Warren Buffet. Getting rid of emotions while buying or selling your stocks is one of the biggest challenges that an investor; especially the retail investor, has to face.

ETFs diversify investments across a group of companies related to a sector or a theme. “While ETFs may carry sector-specific risks, the risk of an individual company’s performance is eliminated by the limited exposure to that name or particular company,” says Jain. This is especially visible in sectors like biotechnology where the individual performance of a company can often be binary. By investing in a biotech ETF, investors can remove such stock-specific risks.

ETFs track popular market indices that are constructed using well-established index-creation rules. This results in a well-diversified portfolio across stocks and sectors. Different stocks and sectors will perform differently in various market conditions. An Index/ETF performance will be more balanced or even as compared to individual stock sector performance.

The market goes through sector rotation, where different sectors will emerge as relative outperformers. “Investors who look to buy into stocks/sectors basis past performance may be entering a trade too late. However, by investing in an Index ETF, the investor will benefit from performance of different stocks and sectors by continuing to stay invested,” says Belapurkar.

It’s hard to predict mood swings when it comes to the sea. The quiet sea changes into a rough monster within a few minutes. And so does the markets. An ETF is after all an equity investment and if the market nosedives, so does the investments. The funds give the investor the option to exit just like he can sell off his stocks.

In the fiscal 2020-21 alone, a BSE report says, over 10 million investors entered the equity markets. This is more than double the previous year’s figure. These investors entered the market at a time when equity as an asset class was going through a bull phase, with the benchmark indices recording new highs.

Markets have been going through an extremely volatile phase with the economy stepping into the recovery path and industries trying to heal the wounds inflicted by the last year’s Covid containment measures.  

“These investors are yet to see a bear phase. Very often, after a bull market, there would be a set of investors who would forever move away from equities due to steep losses suffered and having lost faith in this asset class,” says Haria.

In bear markets, if you are holding a stock that falls significantly can result in panic selling, at the same time a well-diversified index will tend to fall to a lesser extent. “Index movement –  where ETFs invest – will be relatively more balanced, given their exposure to a basket of stocks which will move in different proportions,” says Belapurkar.

Market events can impact different stocks disproportionately. “High beta (volatility) stocks decline a lot more than ETFs tracking a broader market during a collapse,” says Jain. Investors who are holding individual stocks may liquidate their positions in such high-risk stocks when panic grips the market. These high-beta stocks are also the ones that usually rebound quickly after a correction. The portfolio performance of direct investors would thus suffer as they do not participate in that upside. For example, IDFC Ltd shares fell almost 60 per cent during the panic in March 2020, while the market fell about 30 per cent in the same period.

A look back at Cast Away evokes the memory of Noland’s repeated failure and eventual success in making fire on that island and when he returns home after over four years he sees all it takes is a click in the lighter. But, by then, he had learnt what it takes to make fire and save it from the raging wind.

Much the same way, a seasoned investor learns how to beat the storm that threatens his investments. “In a growing economy like India, ETFs are an excellent way to beat the inflation, when you are relatively new to the market,” says Ravi.

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Direct Investing

• When it comes to direct investing, the onus of stock selection is on the investor.
• One has to complete all the required due diligence about a company or a stock, decide when to buy or sell, ensure that the portfolio is well diversified, and even decide on appropriate sizing to make the most from the market opportunities.
• At any point in time, one has to be prepared to stomach the losses as well which many a time are unexpected.
• Direct investing leaves room for disproportionate gains and also disproportionate losses which, at times, may wipe out your entire savings.
• It requires time, expertise and most importantly emotional balance to weather the ups and downs of equity markets.

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Exchange Traded Funds

• Easy to trade: You can buy and sell ETFs any time throughout the trading hours.
• Cost efficient: ETFs tend to have lower expense as compared to other investment options.
• Transparent: Most of the ETFs are index-based, so the constituents are well-known
• Easy to select: Because ETFs are traded like stocks, investors can place a variety of order types.
• Diversified: As ETFs track a basket of assets, there is an element of in-built diversification.     
• Comprehensive: When investing in an ETF, the return profile will mirror that of the underlying index.

The writer is a financial journalist