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When markets are soaring to new heights, investors often face a critical decision: Should they stick with traditional asset classes like mutual funds, or explore more dynamic options like exchange-traded funds (ETFs)? In mature stages of a long term bull run, having the right investment strategy is crucial, and we believe that ETFs can offer a compelling solution for managing the complexities of a market that is at all-time highs and where valuations are steep.
What Makes ETFs Stand Out?
Exchange-traded funds (ETFs) are investment vehicles that track specific indexes, assets, sectors, or themes, providing exposure to a diversified basket of securities. Unlike individual stocks, which carry the risk of sharp fluctuations, ETFs offer built-in diversification. This feature is particularly advantageous when markets reach record levels, as it helps mitigate the risk associated with individual stock investments.
For instance, Indian equities had a very bullish month in June 2024. However, if you had bought individual stocks just before election results that came out on June 4th, your portfolio could be actually down for the month as many of the stocks never came back to pre-election results levels. However, by investing in an ETF that tracks the Nifty 50 or some other broad based index, you can spread your risk across a portfolio of securities, minimising the potential impact of any single stock’s downturn.
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Lower Volatility, Higher Stability
One of the standout advantages of ETFs is their lower beta, which measures the volatility of an investment relative to the market. According to a 2024 Morningstar India report, the average beta for Indian equity ETFs is around 0.85, significantly lower than that of individual stocks. This means ETFs are generally less volatile, making them a more stable choice in a mature bull market where outcomes may be very unpredictable.
Thematic and Sector-Based Opportunities
Investing in individual stocks may not always provide immediate exposure to emerging themes or industries. This is where thematic ETFs come into play. Whether it’s the rise of electric vehicles (EVs) or the growth of renewable energy, ETFs allow you to invest in long-term trends by providing investors exposure to an entire value chain and ecosystem of a particular theme through a diverse range of companies. These can include everything from large corporations to smaller businesses at the forefront of innovation.
Identifying undervalued sectors is also crucial when markets are at their peak. ETFs focusing on emerging or undervalued sectors within the broader basket of securities enable investors to tap into potential growth areas that might not yet be fully priced in.
Cost Efficiency and Liquidity
In a volatile and expensive market, keeping costs low is more important than ever. ETFs generally have lower expense ratios compared to actively managed funds, ensuring that more of your money is working for you. This cost efficiency becomes particularly valuable when markets are peaking, as higher costs can erode returns.
Moreover, ETFs offer liquidity, allowing you to enter and exit positions with ease any time that the market is on. This flexibility is essential during a bull run, where swift portfolio adjustments may be necessary to capitalise on market movements.
Potential for Alpha Generation
While ETFs are often seen as a way to achieve broad market exposure, they also offer the potential for generating alpha—returns that exceed the benchmark. By investing in ETFs that target undervalued sectors or smart alpha/beta strategies, you might achieve higher alpha compared to traditional mutual funds.
The Growing Popularity of ETFs in India
As of 2024, the total Assets Under Management (AUM) for ETFs in India has reached approximately Rs 6.5 trillion (Rs 6.5 lakh crore). India has more than 140 ETFs by 2024, this investment vehicle is gaining significant traction in the Indian markets as investors are exploring more passive investing options. ETFs have become a favoured choice not just in the U.S. but increasingly in the Indian market as well. In fact India based ETFs led the charts for Emerging Market ETF inflows in the U.S. for June 2024 with $497 million of inflows.
A Balanced Approach for Bull Markets
ETFs offer a host of advantages that make them an attractive option when markets are at all-time highs. Their built-in diversification, lower volatility, cost efficiency, wide choices and potential exposure to thematic trends provide a strategic edge in navigating high market valuations. As the Indian market continues to evolve, incorporating ETFs into your investment portfolio could be a smart move to generate a smart alpha. By doing so, investors can capitalise on the best growth opportunities while effectively managing risk in a complex and ever-changing volatile market environment.
(By Amit Goel, Co-Founder & Chief Global Strategist, Pace 360)
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