In Part I of this two-part post, I made the case for low cost passive indexing as an effective means of long-term wealth building. So much so that even Buffett has recommended it to his heirs in his 2013 letter to shareholders:

“My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”

You’re thinking, “Great, how do I sign up?”

If you’re an investor in India looking for the best way to adopt passive indexing as your investment strategy, it’s simple. Find the right ETF and invest regularly.

Wait, what’s an ETF?

The accompanying image (click to view full-size), shows the 50 stocks that comprise the Nifty, with their weightage in the index, which is the ratio of the stock’s free-float market capitalisation / total market cap of the 50 stocks.

Even as active investors try and identify the specific stocks that they think will outperform others, a passive indexing investment strategy that tracks the Nifty, will do no such thing, but invest in these 50 stocks in their exact weightage in the index. This means you would buy stocks such that NTPC constitutes 1% of your portfolio while Infosys 6.94%, Asian Paints 1.3% and so on. Now, you can imagine that doing this directly with stocks as a retail investor will be difficult if not impossible since you can’t buy fractional shares, you’ll need a large sum of money to buy shares in proportion of index weightage.

Hence, Exchange-Traded Funds or ETFs.

The asset manager buys blocks of stocks that constitute the index and creates ETF units, where each unit represents ownership of a block of shares that constitute the Nifty. These units are freely tradable on the stock market just like a share of a specific company.

ETFs can be designed to track broad market indices like Nifty, Sensex, CNX100, CNX500 etc. or specific sectoral indices like Goldman Sachs Bank BeES that tracks the Bank Nifty.

The above explanation of ETFs might seem similar to what you know and understand of mutual funds and to an extent index funds (like UTI Nifty Fund, Principal Nifty Fund) are similar to ETFs in the key respect that they try to replicate and track the index.

But there are some key differences between index mutual funds and ETFs:

Liquidity : Unlike ETFs, mutual funds do not trade in real time but at NAV (Net Asset Value) that’s declared once a day. An investor knows exactly what a unit is worth when she’s buying which is not the case in a mutual fund

: Unlike ETFs, mutual funds do not trade in real time but at NAV (Net Asset Value) that’s declared once a day. An investor knows exactly what a unit is worth when she’s buying which is not the case in a mutual fund Structure : An investor buying ETF units is usually buying pre-built blocks of shares created by the asset manager or from other investors. With a mutual fund, the units are created as the money flows in and being sold when investors ask for their money back. This key difference in how they’re structured mean that long-term investors in ETFs are not as susceptible to panic moves by short-term investors who might decide to sell in a rush

: An investor buying ETF units is usually buying pre-built blocks of shares created by the asset manager or from other investors. With a mutual fund, the units are created as the money flows in and being sold when investors ask for their money back. This key difference in how they’re structured mean that long-term investors in ETFs are not as susceptible to panic moves by short-term investors who might decide to sell in a rush Expenses: Mutual funds tend to charge higher fees and have higher expenses than ETFs because of their structure

As a result of these differences, the tracking error of ETFs tends to be lower than that of index mutual funds which translates into higher returns

ETFs in India: A well-kept secret

If you’re an investor in India, there’s a good chance, you might never have heard the term because it gets almost no mention in financial media. Or you might have heard of them but dismissed them as a newfangled mutual fund product and therefore unsuitable for the conservative investor. The reality is however, quite the opposite.

The obscurity of ETFs in India is partly explained by the fact that ETFs are a relatively new product in the investing universe. Even in the US, the breeding ground for innovation in financial products, there were only 94 exchange-traded products back in the year 2000. That number has ballooned to over 1,600 in 2014 (Source).

In India, we’re some way behind. Only ~45 products currently trading on Indian stock exchanges can be classified as ETFs while there are over 360 equity-focused mutual funds. Of the 45 exchange-traded funds, 14 invest in Gold and many others in “non-equity”, debt and money market instruments. Taking a look at the assets under management, presents an even starker contrast.

Chart shows the relative insignificance of ETFs in India compared to income, liquid and particularly equity-focused funds. Equity focused account for 26% (₹3,022 Bn) of assets under management, while non-gold ETFs account for under 1% (₹70 Bn) under management.

Wait, you could say, maybe there’s a good reason why ETFs are ignored.

Let’s compare historical performance of ETFs with their mutual fund counterparts, index-tracker mutual funds.

Two charts below shows the top 5 index mutual funds and top 5 Nifty ETFs (by annual returns over 5 years) and their respective returns over the last 1 years, 3 years and 5 years.

While the returns offered by both groups are similar, which makes sense given they both track the Nifty, notice that ETFs provided marginally higher returns over all three durations. This is explained in large part in the expenses of running an index mutual fund versus an ETF.

The difference in expense ratios and the structural advantage (liquidity) in an ETF over mutual funds, means that ETFs consistently beat index mutual funds in returns delivered. Chart below compares median returns of the top 5 Nifty index funds compared with Nifty ETFs

You’ve now well-versed with the impact of small differences in returns compounded over long time periods to know this could be significant. A minor-looking difference of 0.99% in annual returns (as shown over 5 years in the chart above) results in significant impact on cumulative returns over the long-term.

The average investor-beating investment strategy

Coming back to the Indian investor who does not have the time or inclination to research individual stocks but knows the importance of being invested long-term in equities:

Step 1: Identify ETF

Mentioned above the top 5 ETFs invested in the Nifty. The 50 stocks listed in the Nifty account for ~65% of market value of the Indian stock market. Compared to that the 500 stocks on the CNX500 represents 96% of all stocks that trade in India. However, as of March 2015, no ETF product exists that replicates the CNX500. That said, a passive indexing strategy built around Nifty ETFs offers good coverage of the India story

Since an ETF does not require fund-manager capabilities in terms of picking the right stocks, the key thing an investor should consider is how well it tracks the index. This will be revealed in large part by the expense ratio.

Step 2: Set up SIP

Once you pick your fund, allocate a monthly amount to be invested. Most brokerages offer functionality to set up an SIP with a few clicks. Set one up for as long as you can, a minimum of 12 months

Step 3: Forget about it

Now, the hard part, to do nothing about it and to let compounding to do it’s job, un-impeded

Every 12 months, adjust the SIP amount upward by at least an amount equal to growth in your earnings

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As Indian markets evolve, there should be more such passive index trackers offered by AMCs covering all the major indices. In the meantime, the smart but busy investor could do well to adopt it as his/her long-term investment strategy and beat the frenetic and impatient average investor.

Further reading:

Part I of ‘The investment strategy that beats the average investor’ – The Calm Investor

What is an ETF? An investment you should consider – Motley Fool

About ETFs – Creations & Redemptions – NSE India

ETF vs Mutual Funds – reddit

The real cost of owning a mutual fund – Forbes

All ETFs are not created equal – OneMint