ETFs and index funds: towards the future?
Rafid Fayaz |
Oct. 23, 2021, 1:09 p.m.
There is a saying on Wall Street that in the long run the market always goes up. So it goes without saying that investing in the broader market will yield long-term results.
It will also take the hassle out of tracking the market or paying large fees to asset managers who will follow the market for you. Enter ETFs and index funds.
An ETF or Exchange Traded Fund is a collection of investments, such as stocks, that can be traded on a stock exchange like any stock in a company. It usually holds multiple underlying assets, rather than just one like a stock.
Since there are multiple assets within an ETF, they can be a popular choice for diversification. An ETF can hold hundreds or thousands of stocks in various industries, or it can be isolated in a particular industry or sector.
For example, ETFs focused on the banking sector would contain stocks of various banks in the sector.
Index funds are also based on similar principles. They were introduced in 1973, 20 years before the first ETF. The main difference between index funds and ETFs is that index funds are not traded in the market like common stocks. They can be purchased through brokerage firms or directly from index fund providers.
Isn’t that a mutual fund?
One of the main qualities of popular ETFs and index funds is that they are passive funds. Unlike actively managed funds, such as mutual funds, which try to beat the market, index funds and ETFs go up and down with the market.
One of the most popular index funds is the S&P 500. Here, index funds and ETFs contain stocks from the S&P 500, a collection of the 500 largest publicly traded companies in the United States.
The performance of the S&P 500 Index has a direct impact on the performance of ETFs and index funds.
On the other hand, a mutual fund contains shares of less than companies selected by the asset manager, and the composition of the mutual fund can be changed on a daily or even hourly basis. Mutual funds are actively managed and, historically, actively managed funds have outperformed the broader market.
ETFs and index funds have become essential in the US capital market. These have enabled regular small investors to invest in the large market.
According to a study by Morningstar Inc, index funds and ETFs made up 14% of the U.S. stock market as of August 31, 2019, outperforming their rivals in stock selection such as mutual funds and hedge funds.
This number doubled from 2010 as more and more people lost faith in their fund managers following the stock market crash of 2008. These index stocks are usually passively managed using automation. This reduces the cost of managing portfolios, which translates into lower commissions and fees for individual investors.
Low fees and commissions, lower risk levels and better chances of return have compelled many people, especially young investors, to invest in index funds and ETFs.
The case of Bangladesh
At the end of 2019, the Bangladesh Bank set the maximum deposit rate for banks at 6%. This deposit rate cap has made bank deposits less attractive to individuals. In such a case, the stock market would have been a great place for investors.
But the historically turbulent nature of the local stock market and a lack of financial literacy has kept many people from investing their hard-earned money in the stock market.
However, despite their popularity in the United States and even our Indian neighbor, index funds and ETFs have failed to gain traction in Bangladesh.
Although there are no regulations for index funds in Bangladesh yet, a regulatory framework was prepared for ETFs in 2017. But no ETFs have yet been launched in Bangladesh.
An anonymity-seeking mutual fund manager said: “The Bangladeshi asset market is far from mature enough for ETFs. Since ETFs have many underlying securities in each of them, the market needs these securities to accommodate ETF creators.
He also pointed out that Bangladesh does not have a bond market, which hinders the viability of this type of broad-market fund.
In addition, ETFs require the presence of market makers who act as a kind of intermediary. Market makers try to liquidate ETFs when they are sold by investors.
The lack of market makers makes ETFs totally unsustainable in Bangladesh. Today, the concept of index funds and ETFs remains a dream of the future in Bangladesh.
However, with the right actions on the part of regulators and a change in investor mindset, these broad-market diversified funds may become feasible in the near future.