ETFS In India: The Road To Financial Inclusion Exchange-traded funds could give a boost to the Indian government’s recent efforts to provide broad-based access to financial products and services.

With 1.34 billion people, India accounts for nearly one fifth of the earth’s population. But unlike China, whose demographic profile is growing older faster than almost anywhere on the planet, India has the world’s largest young population — more than 50 percent of its people are below the age of 25. Young developing nations like India could see their economies soar if they invest heavily in human capital and provide jobs and other income-earning possibilities.

Creating opportunities for such large numbers of people requires huge investments. In developing nations, domestic savings form the backbone of investments. An economy can have different forms of domestic savings: financial or physical and by households, private sector or public sector. Of these, household financial savings are generally the largest and most critical.

India has one of the world’s highest household savings rates — in excess of 30 percent. However, the majority of savings go toward the purchase of physical assets like real estate and gold, which are relatively unproductive. At the same time, around 40 percent of the country still lacks access to bank accounts and less than 1 percent participate in capital markets. It is therefore critical to improve the environment for households to participate in the financial system and channel their savings for more productive use.

For first-time investors, ETFs are a simple product compared with investing in individual stocks or actively managed mutual funds.

 

The government of India has made promoting financial inclusion a national objective. In 2014 it announced the Pradhan Mantri Jan Dhan Yojana (the Prime Minister’s People’s Wealth Program), with a goal of giving all Indians access to bank accounts. So far, banks have opened 275 million new accounts, representing about 600 billion rupees ($9 billion) in assets.

Financial inclusion means individuals have access to products and services that meet their needs and are available in a convenient and low-cost manner. This includes not only banking but also other financial products and services, such as insurance and equities. One such category that could contribute toward financial inclusion in India is the exchange-traded fund (ETF). For first-time investors, ETFs are a simple product compared with investing in individual stocks or actively managed mutual funds. ETFs offer the same diversification benefits as mutual funds, along with the trading flexibility of stocks, greater transparency and lower operating costs.

The first exchange-traded fund came into existence in the U.S. in 1993. It took several years for ETFs to attract public interest, but once they did, their volumes took off with a vengeance. Globally, there are now over 4,800 ETFs, representing more than $3 trillion in assets under management. ETFs are available for all major asset classes — bonds, commodities, currencies and equities.

Bollywood Prices

India launched its initial ETF in January 2002 based on the Nifty 50 index — a broad index of 50 large-cap companies across 13 sectors, representing 65 percent of the free-float market capitalization of the National Stock Exchange (NSE). Today there are 13 Nifty 50 ETFs and 28 ETFs based on a variety of other equity indices listed on the NSE.

Equity ETFs trade just like any other stock listed on the exchange. The price of an ETF is derived from the value of its index. For instance, some ETFs trade at one hundredth of the value of the Nifty 50 index. With the Nifty 50 recently trading at 9000, the price of the ETF would be about 90 rupees ($1.37). This means that an investor could get exposure to 50 companies across 13 sectors for less than the price of a Bollywood movie ticket.

In India equities have been the best-performing asset class over the past decade in spite of the global financial crisis. An investor who had invested 100 rupees on January 1, 2007, would have had 204 rupees ten years later — an annualized return of 7.40 percent (which is tax-free because capital gains on equity holdings held for more than one year are exempt from levies).

Nifty 50 Chart for web.png

Unlike equities, gold has long been popular in India, the world’s second-biggest consumer of the glittery metal (after China). People in India adore gold, purchasing it for family celebrations, festivals, marriages and other traditions. Indians also buy gold bars and coins. Part of the reason for gold’s investment popularity may be low financial literacy: Only 60 percent of the population have bank accounts. For those who do, the real returns on bank deposits have been so low — or even negative, as consumer price inflation was higher than the deposit interest rates — it is no wonder that gold became the favorite investment product.

With more than 50 percent of household savings in physical assets like gold and real estate, it has been challenging to get India’s masses to participate in the formal financial system. One solution has been to create instruments that mirror the returns of gold. An Indian asset management company initially conceptualized the idea for a gold ETF in 2002, but it took five years to get the regulatory approvals and launch the first product.

Gold ETFs are a smart way to attract investors. In addition to enjoying any appreciation in the price of the precious metal, an investor avoids all the disadvantages of investing in physical gold, such as the storage costs and issues of purity. Gold ETFs allow investment in small denominations of one gram, helping retail investors to participate. As of today there are 12 gold ETFs listed on the NSE, with total assets of $1 billion.

Pension Power

In 2014 the government of India successfully used an ETF to sell minority stakes in ten of the 47 central public sector enterprises (CPSE) it controls, including Coal India, Indian Oil Corp., Oil & Natural Gas Corp. and Power Finance Corp. The ETF is based on an index developed by NSE group company India Index Services and Products. An asset management company sold the ETF units through a new fund offering and passed the proceeds on to the Indian government against the shares in the ten companies. The NSE then listed the ETF units and made them available for trading. The CPSE ETF allowed the government to divest from ten companies simultaneously and raise $440 million to help meet its fiscal deficit. For investors, it provided an opportunity to diversify exposure across a number of public sector companies through a single instrument.

India’s ETF industry got a major boost in 2015 when the country’s state-run pension fund, Employees’ Provident Fund Organization (EPFO), which has $126 billion in assets and 40 million active subscribers, began investing in equities. The investment was made using ETFs, most of which were linked to the Nifty 50 index. The initial investment made by EPFO was $1 billion, which represented 5 percent of the annual growth in the corpus. With plans to invest 5 to 15 percent of incremental flows every year, EPFO will emerge as an important institutional investor in India. Investments made by EPFO have already resulted in indirect participation in ETFs for millions of account holders.

The key to growing the breadth and depth of the Indian ETF market is improving financial literacy.

 

A variety of new ETFs have been launched in India over the past few years and now are available for broad equity indices, thematic equity indices, gold and fixed income. Overall, there are 57 Indian ETFs, with total assets under management of $6 billion, but the liquidity is still concentrated in just a few products. The key to growing the breadth and depth of the Indian ETF market is improving financial literacy, ensuring that investors understand and accept exchange-traded funds. Indian stock exchanges, asset management companies and even regulators are doing their part, conducting a series of campaigns and programs across the nation to create awareness. For instance, to promote gold ETFs, the NSE holds special trading sessions on occasions like Akshaya Tritiya (a holy day considered auspicious for buying gold).

The role of intermediaries is also critical to creating financial inclusion. To trade ETFs in India, investors need a bank account, a brokerage account and a demat account (where shares are held in electronic form). In this regard, financial intermediaries are the vital link between investors and capital markets; their number has grown substantially in recent years. The NSE now has more than 200,000 trading terminals spread across 2,000 Indian towns and cities. Technology is also playing an important role, as investors increasingly use online trading accounts and smartphones to access capital markets.

In India providing access to formal financial services and products has been a goal for decades. The big recent push toward financial inclusion has emanated from the government’s scheme, started in 2014, to have bank accounts for everyone. Policymakers are exploring other ways to facilitate greater inclusion and undertaking a range of measures to include the underserved within the formal financial system. Capital markets can also play a significant role in creating financial inclusion by making available to the masses simple financial products like ETFs.

 

Onkar Phadnavis is a Senior Manager at the National Stock Exchange of India. He is currently a Fellow in the IFC–Milken Institute Capital Markets Program in the U.S. As part of the program, he is completing a four-month internship at WorldQuant, LLC.

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