ETFs constitute only a small proportion of the fund management industry in India. It is, however, heartening to note from the New Fund Offer filings on the SEBI Web site that the concept is gradually catching on. Axis Asset Management, for instance, has filed offer documents to launch ETFs on FMCG and metals indices. Such products offer low-cost exposure to a sector. But the question is: How can ETFs offer low-cost investment solutions to the mass-affluent investors?

Using the 4-box approach to active-passive management, this article explains how investors can use ETFs to create target portfolios. It also shows how asset management firms can position next generation (Next-Gen) ETFs as investment solutions rather than as investment products.

Passive-Active Approach

The 4-box matrix to active-passive management separates the investment decision into two components — creating the exposure and managing the exposure. The former relates to security selection decision and the latter, to market timing.

Fund managers can be said to actively create the portfolio when they engage in security selection decision. Likewise, investors can be said to actively manage the portfolio if they buy-sell their holdings frequently and time the market. In the 4-box matrix, such investments can be said to follow an active-active approach. At the other extreme is the passive-passive approach, where an investor buys an index fund and holds it till the investment horizon. In between are passive-active and the active-passive approaches.

At present, asset management firms offer ETFs on available market indices (passive security selection) such as Nifty, Junior Nifty and other sector indices. Such products fall into either the passive-passive or active-passive approach.

In passive-passive approach, the investor buys the ETF and holds it till the desired investment horizon. In the active-passive approach, the investor takes ETF (passive) exposure to actively buy-sell and profit from short-term price movements.

Asset management firms should also offer innovative products that fit the passive-active approach. This requires creating a portfolio through active security selection and then managing the portfolio passively.

Investment solutions

Suppose an investor wants to buy a luxury car five years later; she can invest in an index fund and hold the exposure for five years — the passive-passive approach as per the 4-box matrix. Another option is to invest in an active fund and manage her position actively — the active-active approach.

An optimal approach would, however, to be to create a portfolio that will help the investor minimise any shortfall in value five years hence.

This shortfall can arise due to two reasons. One, the portfolio can decline in value at the investment horizon due to fall in the broad market. And two, the shortfall can exist because of price increase in the luxury car.

The portfolio should, hence, carry stocks that contribute to general upside gains as well minimise inflation risk associated with the investment objective. Inflation risk on the car could be minimised by taking exposure to metals, for instance.

Security selection process, therefore, is more important than active management of the portfolio. In other words, a passive-active approach would be optimal for creating such target portfolios. Next-Gen ETFs on designer indices should, hence, be an optimal choice.

Asset management firms cannot offer ETFs to achieve unique investment objectives such as buying a luxury car or having an exotic vacation. They can instead create ETFs to help investors map their lifecycle requirement. Such requirement falls into three categories — aspiration assets, lifestyle assets and protection assets. A luxury car may be an aspiration asset while a house is a lifestyle asset. Protection asset essentially refers to insurance contracts and money market funds.

The need is to build meaningful indices to map the common lifestyle needs of investors. Offering ETFs on designer indices built to capture lifestyle needs would be optimal because return from security selection is more sustainable than return from market timing. It may, perhaps, take a while before asset management firms consider introducing such products. Investors can meanwhile create such portfolios through direct equity exposure with the help of their investment advisors.

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