Is it wise to invest in exchange-traded funds (ETFs) at the moment?

ETFs are like a passive mutual fund and are indexed to an underlying. For example, you can have an index ETF that is benchmarked to the Nifty or the Sensex.

Oct 13, 2018 11:10 IST India Infoline News Service

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At a time when the Nifty lost ~700 points and the Sensex lost over 2,200 points in a single week, the big question is what should be your investment strategy? It is easy to say that quality blue chips are available at cheaper valuations, but the worry is that company-specific factors can really destroy value in a short span of time. We saw that in the case of companies such as Yes Bank, Indiabulls Housing Finance, Dewan Housing, HPCL, and BPCL in the last few weeks. What should be your approach in such a market?
 
A simple answer to this challenge would be to focus purely on a long-term equity fund SIP, which has the potential to generate returns over the longer time frame. But, that is a more passive approach to investing, which is core to your long-term financial goals. Is there any immediate solution? The immediate solution needs to address two critical factors: making the best of this volatility and protecting your risk in these uncertain times. Interestingly, exchange-traded funds (ETFs) could be the answer.
 
What exactly are ETFs?
 
ETFs are like a passive mutual fund and are indexed to an underlying. For example, you can have an index ETF that is benchmarked to the Nifty or the Sensex. Alternatively, you can have a commodity ETF that is benchmarked to the price of gold or other commodities. There is also a third option available to you, and that is to opt for global ETFs where you participate indirectly in global markets.
 
An ETF is like a closed-ended fund. The corpus of the ETF does not change daily as in the case of an open-ended mutual fund. On the contrary, buyers and sellers of the ETF trade on the stock market platform. These transactions are executed exactly like you buy and sell shares through your equity trading account and held in your demat account.
 
What is a good ETF strategy at this point of time? Here is a model!

 
Using ETFs to hedge flow volatility
 
One of the big risks that mutual funds (typically open-ended funds) run in the current market is the threat of redemptions. While retail investors are still holding on, there is a lot of selling in debt and money market funds from corporate and institutional investors. As we have seen in 2008 and 2011, it does not take too long for the selling contagion to spread to retail investors too. This is where ETFs are relatively safer.
 
Unlike in the case of open-ended mutual funds, ETFs are not subject to redemption pressures. While the market price of the ETF is still benchmarked to the underlying, it is not vulnerable to sudden outflows because every seller requires a buyer. In the midst of a pullout of funds, an ETF can be relatively more stable. Outflows from funds forces fund managers to hold on to more cash and also to take sub-optimal decisions on liquidity generation. You can escape that risk via ETFs.
 
Using an Index Fund for phased investing (SIP approach)
 
Instead of allocating your money lumpsum, you can adopt a phased approach. The ETF will give you opportunities to enter the index at lower levels. Historical experience has been that, in the long run, indices have generated positive returns. For example, the Sensex has been a 38-bagger since inception despite all the intermittent corrections and bear attacks. You can replicate the index SIP via an ETF. Opt for an Index ETF to ensure that you are able to hedge the risk of your stock-specific portfolio and also acquire the index at a much lower average cost.
 
Using Gold ETFs to hedge global geopolitics
 
Gold ETFs are benchmarked to the price of gold, and hence, your returns will be dependent on gold prices. However, gold has two favourable circumstances at this point of time. First, the global geopolitical scenario is fairly uncertain. There is strife in the Middle East, sanctions on Iran, while the US and China are trying to indulge in sabre rattling. This kind of situation is normally positive for gold prices. Second, if the trade war intensifies, the big casualty could be global currencies that could lose value. When currencies lose value rapidly, it is gold that is the big beneficiary, at least as an alternative currency. Of course, gold is a hedge in your portfolio and always will be. Thus, if your gold allocation is in the range of 8% to 12%, increase allocation to gold to the upper end of the range via gold ETFs.
 
Use global ETFs as a hedge against the falling rupee
 
This is an important allocation decision. Today, you have the facility of participating in ETFs that are benchmarked to the US markets or probably other global markets like Japan. The US markets are enjoying a heady combination of high growth, low unemployment, rising inflation, and a strong dollar. This has led to a solid bull rally in the Dow and the NASDAQ. By buying into global indices, you not only participate in global market movements but also get a natural hedge against the dollar.
 
ETFs are simple and flexible and offer a good mix of returns and risk diversification. This could be the time to try these products out.

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