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Debt ETFs are now in India. What does the offer document not say?


The article references a conversation between Mike Green, Portfolio Manager at Thiel Macro LLP and Raoul Pal, CEO of Real Vision, where they discuss the effects of passive investing on global markets. The interview was published on Real Vision on 11 December 2019.


ETFs are a good thing, as they bring down costs with lower fees and let investors ride the wave of the index. Conventional wisdom tells us that, over the long term, as more active managers work and try to find alpha, they invest in better companies. In due course, these companies are valued higher and constitute indices, such as the NIFTY or the SENSEX. Consequently, an investment in these indices tends to offer the collective power of all active managers. Equity ETFs on these indices have outperformed the average actively managed fund, across India as well.


ETFs increase in value as the value of the index constituents they track, increase in value. As they are typically market weighted (weighted by their size), we notice that a small move in a big constituent tends to move the whole index (and the ETF) more, compared to a similar move in a smaller constituent. With debt ETFs, the situation is a little different - ETFs are weighed as per loan outstanding. Higher the loan outstanding, higher its allocation in the index. Compare this to equity ETFs, where we allocate more to companies that have larger public shareholding; in essence, according to Green, you are choosing your winners by the amount of debt they have (debt ETFs), rather than their fundamentals (equity ETFs). Thus, the selection of index constituents becomes paramount. With the current version of the Bharat Bond ETF, we have AAA issues of PSUs in the mix; these carry very low risk.


There is a lot of demand for reducing interest rates, to support asset prices, across India and globally. These interest rate moves can materially change the value of a debt ETF. A cut in interest rates, can increase the value of the ETF (as bonds increase in value), while a similar increase in interest rates, can reduce the value of the ETF. But, these values change during the day, and we could see a big dispersion between actual price traded on the exchange, compared to the underlying asset value. For instance, consider that there is an upcoming MPC (Monetary Policy Committee) meeting due at the end of the day, and the whole market is siding towards an interest rate increase - in this case, the ETF can materially trade lower than actual asset value, by a substantial amount. A 0.25% increase in interest rates can reduce the value of a bond by more than 1%. So, a simple change in interest rates, would mean you could lose 1% by selling the ETF on that particular day, without even an official announcement due yet. The market is not efficient.


Debt ETFs are a great way to get cheap exposure to a curated set of underlyings. A typical size-weighted debt ETF does not capture the collective market power as equity ETFs do. Also, there could be changes to the index constituents, where allocations can move towards lower quality and higher credit risk. Hence, this curation is even more important, given the size-weighted approach. For now, the Bharat Bond ETF is clean with only credit ratings of AAA, and a fixed maturity period of 5 years and 10 years.