Monday, December 6, 2010

Portfolio ETFs for lifecycle investment Source: BUSINESS LINE (29-NOV-10)

Author: B. Venkatesh

It has been a while since ETFs were introduced in India. Its popularity is yet to grow, despite obvious benefits. Many look at ETFs as an alternative exposure to index funds. The question is: Can ETFs be used to generate cost-effective alpha and beta exposure for the investors?

This article discusses how ETFs can be used effectively in the core-satellite portfolio. It first explains the benefits of ETFs. It then discusses the process of using ETFs for beta and alpha generation. ETFs on asset classes such as bonds and commodities, which when introduced, could offer complete portfolio solutions for lifecycle investment.

Arbitrage and cash drag

ETFs moderate the cash drag and the price arbitrage problems faced by open-end and closed-end funds respectively. Consider the open-end fund. Cash drag refers to the lower returns that a portfolio may earn because it holds cash to meet daily redemption requirements of unit-holders. Closed-end funds, on the other hand, trade at a discount to the NAV.

ETFs sidestep the issue of cash drag by redeeming units in kind. That is, institutional investors do not get cash when they redeem units. They instead receive the underlying shares that constitute the benchmark (say Nifty Index) on which the ETF is based.

Likewise, ETFs reduce the NAV discount by allowing institutional investors to engage in arbitrage when the market price of the ETF is different from its NAV.

Besides, ETFs carry lower management fee compared with even passively-managed open-end funds. All these features make ETFs a desirable investment in any portfolio.

ETFs are primarily passive structures, though some active ETFs do exist in the US. ETFs, therefore, logically form part of the passive equity core within a core-satellite portfolio.

The core-satellite framework separates the beta exposure from the alpha mandate.

That is, the core portfolio contains pure beta or market exposure while the satellite strives to generate alpha or risk-adjusted excess return over the benchmark index.

We prefer ETFs on broad-cap indices such as the S&P CNX 500, as it helps investors get cheap market exposure to equity as an asset class. The Indian asset management industry does not yet offer such products. Investors have to therefore, settle for a passive exposure to a large-cap index such as the Nifty Index for their equity core.

Note that investors face a similar choice problem when they use open-end index funds.

We next discuss how ETFs can be used to generate excess returns over the benchmark index.

ETFs can be used to generate alpha in two ways. One, investors can buy-sell ETFs to generate excess returns. This is possible because ETFs are traded like stocks, unlike open-end funds that can be bought from a mutual fund complex only at the end of the day.

And two, ETFs can be used to back out the beta exposure in a fund. Suppose an investor buys a mid-cap fund.

Note that the mid-cap contains both alpha and beta exposure while the mid-cap ETF has only beta exposure. The investor has to first compute the relationship between the mid-cap fund and the mid-cap ETF.

Then, the investor has to use this relationship to short appropriate units of mid-cap ETF. Shorting beta-adjusted mid-cap ETF neutralizes the market exposure of the mid-cap fund.

And what remains is the alpha return! At present, investors can set-up such ETF alpha strategies in the banking sector and in large-cap stocks.

Conclusion The use of ETFs in the satellite portfolio is only constrained by the availability of products in the market. While investors can now take exposure to gold ETFs, alternative and synthetic ETFs such as commodity ETFs (besides gold) hedge fund ETFs or Swap-based ETFs are yet to be introduced in the country.

Taken together, these products can help investors create a portfolio of ETFs to completely map their lifecycle needs.