ETFs – their impact on your investments?

Exchange traded funds or ETFs, as they are popularly known as, is one of the vehicles to invest your money in equity markets.  Since they invest in benchmark index in the same proportion as its constituents, their performance is similar to the benchmark they track and they have low tracking error as well as low operating cost.  All this making them as one of the important avenues of investment.  They are hugely popular in the developed countries and are slowly catching up in countries like India. 

In India, many fund managers are able to give returns exceeding the returns generated by the index funds and hence investors correctly prefer mutual funds more than the index funds.  However, as capital market develops, becomes more efficient and it gets impossible for fund managers to gain above normal returns, ETFs will become one of the prime vehicles of investment.

In countries like US where funds are available cheap, exchange traded funds have started blossoming because they invest in the indexes of emerging markets and give better returns. Since large sums of money is invested in ETFs which flows in to the stocks of the index, it should be interesting to know how this affects the performance of individual stock and of capital market overall.

Jefrey Wurgler, Nomura Professor of Finance, NYU Stern School of Business has researched the Economic Consequences of Index-linked Investing in his NBER paper and has come out with interesting conclusions.  He says that “.. index-linked investing is distorting stock prices and risk-return tradeoffs, which in turn may be distorting the corporate investment and financing decisions, investor portfolio allocation decisions, fund manager skill assessments, and other choices and measures.  These effects may intensify as index-linked investing continues to grow in popularity.”

This conclusion is interesting in many ways.  As a particular stock forms part of an index, all the ETFs are required to buy that stock till its weightage in the index.  This pushes up the prices of that particular stock as it enters the index.  Conversely, if any stock is removed from the index, ETFs sell that stock leading to declining stock price.  Mr. Wurgler observes that “On average, stocks that have been added to the S&P between 1990 and 2005 have increased almost nine percent around the event, with the effect generally growing over time with index fund assets.  Stocks deleted from the index have tumbled by even more.”  Here the event being that particular stock included in the index.

Similarly, as the fund flow increases to ETFs, these funds buy the underlying stocks pushing up their prices and improving their returns which in turn attract more investments in ETFs (“return chasing feedback loop” as per Mr. Wurgler).

To conclude, ETFs are good investment vehicle, more particularly where capital markets are more efficient.  For countries like India, their importance will grow as the capital market becomes more efficient.  They can form small part of your equity portfolio with diversified equity mutual funds comprising larger portion.

As usual, comments appreciated.