Why US-listed ETFs are better than rupee-denominated Indian funds

Transcript

Hi, this Viram from Vested! And today we are going to be talking about three reasons why investing in US-listed ETFs might actually be a better option than investing in the same ETF that is based in India and is rupee-denominated.

The three reasons that we are going to cover are, one, expense ratio, second how you could actually be paying more for your rupee-denominated ETFs, and third is tracking error.

Let’s start with the 1st reason, which is expense ratio variation.

Before we get going, let me actually explain to you what an expense ratio means. So this ratio is actually calculated by dividing the fund’s total operating expenses by the average total dollar value of all the assets in the fund.

Basically the lower the expense ratio, the better it is for an investor. Indian funds that have been investing internationally have a much higher expense ratio compared to the US equivalent. For example, the expense ratio of the S&P 500 or Nasdaq 100 ETF in India ranges from 0.5% to 1%, while US expense ratios for the same are between 0.03% to 0.05%! This difference actually adds up over time. The Indian fund is actually 10 times more expensive than the US fund!

Next, let’s talk about the 2nd reason, which is the ETF discounts and premiums that you actually might end up paying in India.

So before that lets understand the basics, an ETF unlike a mutual fund has two types of prices. Since the ETF is traded on an exchange, it has a market price. This is the price at which the ETF can be bought or sold during the trading period and is driven by supply and demand. It’s the market price. Now, along with the market price, an ETF also has a Net Asset Value or NAV that is derived using the actual market price of the underlying securities in the index that the ETF is tracking.

For example, the NAV of an S&P 500 ETF will be calculated using the actual price of the 500 underlying companies. Now what happens is when the markets are open, market prices are updated almost every second right, like every stock, whereas the NAV of an ETF is updated almost every 15-20 seconds.

Now, a situation can arise where the ETF market price actually goes much higher or lower than the NAV. If this happens in the US, there are actually special entities that ensure that this gap is kept as low as possible so that you get the actual value of the underlying index. For example, if you’re investing in a Nasdaq-100 ETF the variation between the NAV and the Nasdaq 100 price is typically less than 0.03 percent.

But for the same fund in India, when the India markets are open, the US markets are shut. So this means that the market price which is determined by the exchange or buying and selling demand, it’s changing constantly, but the NAV which is dependent on the underlying securities is actually constant because the US markets are shut.

So this means that because of market price fluctuation you might actually buy the ETF at a much higher or lower price than the underlying NAV! When the markets are super volatile, you may end up paying a significantly different price than the actual underlying index of the ETF. For example, in 2016, the Nasdaq fund in India saw premiums as high as 17%. Thus, as an investor, you would have paid 17% higher than the actual value of the ETF!

Okay let’s look at the last reason now, which is the tracking error. In India based ETF a tracking error is caused due the way dividends are treated and foreign exchange costs. So when you get dividends from an ETF listed in the US it gets credited directly in your account. But in the India listed ETFs the dividends are automatically reinvested and that’s why it introduces an error between the underlying index and the value of the ETF.

Secondly, the funds that you are investing in through an India based ETF are actually converted into USD and then converted back into INR when you withdraw the money. This currency conversion also introduces a slight tracking error because of the costs. This error adds up year on year. So over the last 5 years, the India-listed Nasdaq 100 ETF has approximately underperformed the US by about 10-15%!

So in conclusion you now know how investing in US-listed ETFs can be better because of lower expense ratios, lower discrepancies in its value – the underlying ETF value and actual market value, and lower tracking error.

Alright, that’s it from my end, stay tuned for more!