In this article, we will look at how ETFs can help us build a portfolio. We will also discuss why investors should follow the portfolio-first approach.
Most investors start investing by selecting an instrument. One will first pick up a mutual fund, add a few stocks, or an ETF, but this is not how one should approach investing.
The right way to approach investing is to define the portfolio that one wants. This, in turn, depends on the goals and risk tolerance of the investor.
The objective of this article is not to discuss the right way to build a portfolio (we will discuss that in the next article). But here are a few things that one must consider while building a portfolio.
It is essential to diversify your portfolio across both asset classes and securities.
If you invest in a low-cost instrument, you have already increased your returns. Suppose you invest in a low-cost investment option that has a 0.5% lower expense ratio than that of your friends. By investing in it you have already increased your returns by 0.5%.
Investors must rebalance their portfolio periodically. Rebalancing allows investors to come back to the original allocation and align the portfolio with the objective.
If we look at the above three essentials of a good portfolio, ETFs are the best investment option available.
At the beginning of this article we talked about two levels of diversification: diversifying across multiple securities and diversifying across asset classes.
Since ETFs track indices that hold multiple securities, they already provide the first level of diversification.
There has been some criticism of market cap indices for not being adequately diversified. This is because they tend to go overweight on stocks that have the highest market capitalization. But this criticism (perhaps valid) applies more to indices than ETFs. You can always select an equally weighted index ETF.
Diversification can also be achieved by investing in an index fund. Index funds have a low expense ratio, but it is slightly higher than ETFs. One of the important advantages that ETFs have over index funds is the ease of rebalancing.
ETFs are cheaper than index funds and much cheaper than actively managed mutual funds. If you are looking to invest in a diversified basket of securities, ETFs are the lowest-cost option available.
Here is a diagram that compares the cost of the Indian large-cap universe.
The average cost of ETFs tracking the Nifty 50 index is 0.14% lower than that of direct index funds. This compounds over the long term.
The cost of ETFs being lower than index funds is not an India-specific phenomenon. Even in the US, the average expense ratio of index ETFs was 0.09% less than that of passive index funds in 2020.
We have already discussed the importance of periodic rebalancing. An ETF-based portfolio is much easier to rebalance than an index fund portfolio. It’s also more efficient.
Remember, ETFs trade on a stock exchange, and it is possible to execute the entire rebalancing in real-time. In contrast, a portfolio of index funds will require two legs: redemption and purchase, and the entire rebalancing process can take between 1-3 days (depending on the type of funds being sold).
If your portfolio has index funds from the same AMC (which may not be feasible and is not advisable), you can execute rebalancing through switch transactions.
However, you will still face a 3-day lag (if you are selling equity-based funds). If your portfolio strategy has tactical elements, you cannot execute it through index funds.
Further, recent SEBI regulations have imposed 2-factor authentication for switches and redemptions. This makes rebalancing even more cumbersome.
With index funds, you are exposed to multiple rebalancing risks, – big unfavorable price movements, and missed rebalancing.
ETFs have a few issues, like the transaction costs incurred during rebalancing.
Investing and rebalancing ETFs comes with various costs, such as brokerages, Securities Transaction Tax (STT), bid-ask spreads, liquidity, and market impact costs. These costs, if not properly managed, can easily exceed the cost advantages that ETFs have over index funds. This is even more important in the Indian context, where many ETFs have low liquidity.
One major disadvantage of ETFs in India is the limited number of options available. The majority of ETFs are focused on tracking large-cap indices or gold, with very few options for sector-specific, thematic, or international assets. This can make it challenging to construct a diversified portfolio that meets individual investment goals.
Many argue that a long-term investor should rather invest in index funds than ETFs. Only tactical traders should use ETFs. This argument has merits.
We, however, have a different take. We believe that for retail investors with smaller portfolio size, if we select ETFs with proper care (discussed here) and keep transaction costs in check, a portfolio of ETFs makes more sense than an index fund, even for long-term investors.
The lack of options remains a challenge, but it is improving drastically. A few years ago, we didn’t have enough smart beta indices. Today, we have at least one for each of the major factors. So even this problem can be circumvented. And things will only improve going forward.
In our last and final blog of this series, we will create an ETF selection framework for choosing the most suitable ETFs for your portfolio.
ETFs or exchange-traded funds are one of the cheapest investment options available. Their expense ratio is very low compared to actively managed mutual funds.
Investing in ETFs in India has drawbacks such as having a limited number of options, low liquidity in most ETFs and rebalancing portfolio involves a high rebalancing cost.