Should investors place their sector bets via ETFs?
With the rapid growth in passive investing, fund houses are expanding the options for investors to take these sector bets through exchange traded funds (ETFs) rather than actively managed sector funds. ICICI Prudential Asset Management Company (AMC) and Axis AMC launched healthcare ETFs over the past month. The large AMCs increasingly cover three major sectors through ETFs: IT, healthcare and banking and there are plans to launch FMCG ETFs as well.
Mint is examining whether investors who plan to focus on particular sectors should use ETFs as a vehicle.
In April, sector and thematic funds recorded the highest net inflows of all equity sub-categories at ₹1,705 crore. Investment professionals often seek to generate alpha (excess returns) for clients through sector funds.
“In October, I wanted to allocate more of my clients’ portfolios to metals and there was no sector fund available for that. I solved the problem by partnering with a fintech platform, but it was a tedious process, ”said Anand K. Rathi, founding partner of Increase Capital Services LLP.
A Sebi filing by ICICI Prudential AMC for a metals and energy fund of funds investing in the First Trust Strategic Metals and Energy UCITS Fund shows that an industry is quickly waking up to this need. A Sebi circular in February 2019 provided a framework for mutual fund companies launching sector ETFs.
“According to Sebi’s rules, a sector index can have a maximum weight of 35% in a single stock and the portfolio must have a minimum of 10 stocks. This has brought clarity to index providers and asset managers. In India, there are different types of investors and we believe that a part of them will probably prefer the ETF route given its low costs and transparency. We launched a banking ETF in 2019, followed by an IT ETF and a private banking ETF. We are also exploring an FMCG ETF, ”said Chintan Haria, head of product development and strategy at ICICI Prudential AMC.
The sharp increase in the number of direct equity investors who have demat and trading accounts has also made ETFs a more accessible vehicle. ETFs are bought and sold on the stock exchange.
The number of new demat accounts opened in FY20 was the highest in at least a decade at 4.9 million, an increase of 22.5% over the 4 million accounts opened the previous year . The total of dematerialized accounts at the end of fiscal year 20 stood at 40.8 million, compared to 35.9 million at March 31, 2019.
Granted, investors can invest directly in stocks that are part of a sector, but this activity is heavy and requires active portfolio rebalancing as stocks change weight in sectors. An ETF offers a “pre-packaged” way to invest in the sector by including stocks belonging to a sector such as IT or pharma in proportion to their index weighting. Some AMCs have chosen the ETF route exclusively to individual sectors rather than active sector funds.
“We didn’t launch any sector fund because we didn’t think it was the right vehicle for investors. Our sector products are ETFs, which we believe are suitable for sophisticated investors with a sector vision. ETFs can effectively capture industry returns, ”said Ashwin Patni, Head of Products and Alternatives at Axis MF.
Axis MF launched a banking ETF, technology ETF and healthcare ETF in November, March and April, respectively.
Investing in sectors through ETFs rather than actively managed MFs has clear advantages. Firstly, there is no exit charge and therefore you can take short term positions in sectors through ETFs. Active funds generally have exit charges for short holding periods.
Second, you don’t take the risk that the fund manager gets it wrong – you own stocks in the sector in proportion to the weights in the index. Actively managed funds in several categories have underperformed indices for several years, according to the SPIVA report published by S&P Dow Jones Indices.
Third, ETFs have lower expense ratios than actively managed funds, reducing the costs investors face.
However, advisers are cautious about taking this route. “I think there should be more sector funds, but actively managed funds. When you invest in a sector fund, you are doing it with an expectation of high return, so cost shouldn’t be a big deal, ”said Rathi.
Investing in sector funds is a bet concentrated on a few stocks. It is a risky proposition. “In general, I don’t recommend sector funds. If the client is determined to participate, I don’t recommend investing more than 10-15% of their portfolio, ”said Kalpesh Ashar, founder of Full Circle Financial Planners and Advisors.
However, for savvy investors who understand particular sectors, ETFs have provided an additional avenue.
ETFs involve various risks – they may trade at high premiums or discounts from the published net asset value of the ETF, and their liquidity may be poor.
The ETF trend is still emerging, with the overwhelming majority of sector or thematic funds being actively managed, which may prompt investment advisers to remain cautious. “Given their high risk nature, you have to choose either an actively managed fund or a combination of actively managed funds and an ETF. I would not suggest an ETF-only sector investing approach, ”said Ashar.
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