The Hindu Business Line : `Investors should have ETFs in their portfolio' — Mr Rajan Mehta, Executive Director, Benchmark Mutual Fund

AS a tiny new entrant to the Indian mutual fund market, Benchmark Mutual Fund would probably not have stood a fighting chance of being noticed except for one fact. From inception, it has focussed on just one kind of product — Exchange Traded Funds (ETFs) and it plans to stick to its knitting for now. Mr Rajan Mehta, Executive Director, Benchmark Mutual Fund, puts up a spirited defence of index investing and talks about how the ETFs have an edge over conventional index funds. Excerpts from the interview:

In India, quite a few actively managed funds have managed to outperform the index. So, what is the case for investing in index funds?

If you look at the rankings of the top performers among equity funds from year to year, the funds that figure in the top ranks keep changing. A fund which is the top performer one year can slide to the bottom the next. Therefore, it is quite difficult for investors to choose among the actively managed funds. An investor who is in the wrong fund in a bull market may lose out on much of the returns from the rally. Conversely, in an index fund, he is quite sure his returns will match that of the index.

Indices such as the Sensex or the Nifty do not capture action in a large section of the market. They have heavy weightages in one or two stocks. Is it a good idea for investors to replicate such indices?

I agree that the indices such as the Nifty and Sensex are influenced by a few stocks. This is why I feel we need to have many index-linked funds in a portfolio. We would like people to own a portfolio of ETFs, based on their view of the markets. For instance, the Nifty has high weightages to petroleum and technology stocks. But the Junior Nifty is dominated by banking and pharmaceutical stocks. If we offer a portfolio of the ETFs on different indices, investors can switch between these funds for sector rotation.

Should floating stock, rather than market cap, be the criterion used to include stocks in an index?

The debate about whether indices should use the floating stock or the market cap is ongoing. Globally, indices such as the MSCI (Morgan Stanley Capital International) have been moving towards free float criteria to include stocks in the indices. But this is mainly because it would be difficult for the MSCI to get data about the impact costs for each of its stocks (impact costs show the effect of buy or sell order sizes on prices). But for the NSE, it is possible to shortlist stocks based on their impact costs. And once you use impact costs as the criteria, this takes care of liquidity. You don't need to take floating stock into account.

But the methodology for computation of impact costs does not seem to be perfect...

On a stock broker's screen, you can often gauge the price movement that a big order generates. For instance, you may acquire 1,000 shares of one stock at Rs 100 per share, but as you gradually increase order size, the price will respond. This is exactly what the NSE does to compute impact costs.

But when a fund liquidates a holding, the size of the order is likely to be much larger than a normal order book would display. How then do you gauge impact costs?

Impact cost computations are not expected to factor in abnormally large deals. But as an index fund, I do not really have to worry about such abnormally large deals. Say, an index fund IPO collects Rs 50 crore. You do not have to invest all of it in one day. The underlying value of Nifty shares traded on one day is around Rs 2,000 crore. If the fund phases out investments over a period of time, it may not be too difficult to contain impact costs. True, certain stocks in the Nifty, such as P&G, may have impact costs even if you buy small quantities. But the advantage is that, the weight of such stocks in the index is quite low. This reduces the impact costs of indexing, as a strategy.

The Nifty BeES fund size has shrunk from Rs 21 crore just after its launch to Rs 7 crore now. Why?

The initial investments in the fund were from the three market-makers, the authorised participants who invested equal amounts in the fund. Subsequently, these market makers sold their units to genuine investors. In fact, we have grown since launch. After starting with three, the fund now has 600-700 investors.

The tracking error for your fund has been the lowest among index funds. Would a larger corpus size enhance tracking error?

I don't think so. There are three sources of tracking error for an index fund. An open-end fund needs to maintain cash to meet redemption pressures. The cash creates tracking error. An ETF swaps shares for units, so it avoids this. Secondly, in an open-end fund, there is a lag between the time an investor enters the fund and the time the fund invests it. We avoid this too in an ETF. Thirdly, an index fund has to rebalance its portfolio to take care of changes in the weightages in the index. An ETF too is subject to this kind of tracking error. But we try to minimise this through live re-balancing. Essentially, the ETF structure eliminates two out of three sources of tracking error.

Is there a possibility of an ETF modelled on more broadbased indices such as a BSE 200 or S&P 500?

There are not enough volumes in all these stocks. Usually, the ETFs investing in broadbased indices, such as the Russell 2000 in the US, do not actually invest in all of the 2000 stocks. They follow a process of optimisation by which they choose and invest in the most representative stocks in such indices. If this is to happen in India, SEBI guidelines also have to change. Currently SEBI allows index funds only if they fully replicate the index.

In India, the indices also appear to be quite "actively" managed, with a number of changes each year. Will this not increase your costs and thus your tracking error?

Yes, there are a number of changes to the indices. But usually, this is for weeding out less liquid stocks in favour of more liquid ones.

This helps us. Further, I do not think there are any subjective judgments here, inclusion or exclusion is subject to predetermined parameters. For instance, if a stock in the Nifty Junior rapidly picks up volumes it usually goes to the Nifty. In fact, the Nifty Junior is used as an incubator for Nifty stocks.

Does this mean that you will have to rebalance Junior Nifty BeES more often than your Nifty BeES?

Yes. But we benefit by managing both a Nifty-based ETF and a Junior Nifty-based one. SEBI allows us to make inter-scheme transfers and we can easily move a stock from one scheme to another as such changes happen.

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