Motilal Oswal AMC has launched a debt ETF (Motilal Oswal 5-year G-sec ETF) to track the performance of Nifty 5-year Benchmark G-Sec Index.
Should you invest in this ETF?
Before we get to the “Yes” or “No” answer, let’s first look at the Nifty 5-year benchmark, the pros and cons of this ETF, and look at the benchmark performance for the past 15 years.
What is Nifty 5-year Benchmark G-Sec index?
I reproduce the excerpt from Nifty Indices website.
The ‘Nifty 5 yr Benchmark G-Sec Index’ is a single bond index tracking the most liquid 5-year benchmark security issued by the Government of India. The Index seeks to measure the performance of the most liquid Government of India bond in the 5-year maturity segment. The index is reviewed on a monthly basis.
So, the index consists of a single Government security. To be eligible, the Government security must have a residual maturity of 4-6.5 years. For more on how the bond is selected, refer to the index methodology.
As on October 31, 2020, the index comprises a single G-Sec bond. 5.22% GS 2025 (IN0020200112).
Motilal Oswal 5-year GSec ETF will attempt to replicate the performance of this index.
What are the pros of Motilal Oswal 5-year G-Sec ETF?
- No credit risk: Your investment will be in a Government Bond. Hence, there is no credit risk. If
- Passive: It is an ETF (index fund). Hence, there is no active fund manager risk. Moreover, you can expect this to be low cost. In the brochure, it is mentioned that the total expense ratio for this ETF shall be 0.22% p.a. Not too high, not too low either.
- Tax efficiency: It is a debt ETF. The tax treatment shall be the same as debt mutual fund. If you hold on these ETF units for over 3 years, the resulting gains shall be considered long term capital gains and be taxed at 20% after indexation. Thus, those in the highest income tax brackets may like this product.
What are the cons of Motilal 5-year G-Sec ETF?
- It is an ETF: After the NFO (new fund offer), if you want to invest, you will have to buy the ETF in the secondary market. Similarly, if you want to sell, you must sell in the secondary market. And you can’t be sure of the liquidity in the secondary market. All the problems in ETF transactions will apply to this ETF too.
- Transaction costs: There will be transaction costs (brokerage etc) when you buy/sell this ETF in the secondary market. These will impact your overall returns.
- Liquidity: Lower liquidity can lead to higher bid-ask spreads and impact cost. This can affect your overall returns.
- ETFs have the concept of Price and NAV. NAV is the value of the underlying assets (just as in mutual funds). The only difference is that MF NAV is available only at the end of the day. ETF NAV keeps fluctuating throughout the day. Price is the value at which you buy or sell in the secondary market (just like you do with stocks). As a buyer, you wouldn’t want to buy at a price that is higher than the NAV. On the other hand, you wouldn’t want to sell at a price that is lower than the NAV. And sometimes, there can be a big divergence between the price and the NAV of ETFs. And this brings inefficiency.
- Tracking Error: All the performance analysis (that I have shown later) is for the index. The ETF has expenses (0.22% p.a. May change) and there will be tracking error. We don’t yet know how closely this ETF will be able to replicate the performance of the benchmark index. And this is all before the transaction costs and liquidity issues etc.
- It is going to be volatile: It is benchmarked to 5-year G-sec index. That means reasonable interest rate sensitivity. We know that bond prices are inversely related to interest rate movements. When the interest rates go down, bond prices rise. On the other hand, if the interest rates go up, the bond prices go down. While 5-year G-sec index will have a lower interest rate sensitivity than a long duration G-sec index, you will feel the pain if the interest rates rise sharply. I copy an image from Motilal Oswal 5-year G-sec ETF brochure.
While the duration of the 5-year GSec index (and ETF) will keep fluctuating (depends on the coupons, yields, and the underlying bond maturity), you can expect the duration to be around 3.5-4. Not very high, but not too low either.
Note: If you apply in the NFO, you don’t have to worry about transaction costs, liquidity, and the difference between the price and NAV (atleast for the purchase leg) since the Motilal AMC will issue these to you directly. If you are an HNI, you may approach the AMC directly for a creation unit (that will cost about Rs 9.5 lacs today). And you can do that even after the NFO. However, once issued to you, it becomes your headache if you want to transact (even though Motilal AMC may arrange market making). For a long-term investor in this ETF, transaction costs will be less of a concern.
Nifty 5-year Benchmark G-Sec Index: Performance
The Motilal Oswal 5 year G-Sec ETF brochure compares the performance of the index with bank fixed deposits. However, different banks have different FD rates for different tenures. And even these rates keep changing.
I thought it will be better to compare performance against a debt mutual fund scheme. I picked up HDFC Liquid Fund.
Why HDFC Liquid?
I understand HDFC Liquid is not an appropriate choice. Since a liquid fund invests in very short-term bonds/paper (and that usually means lower returns), I am already making 5-year G-Sec good in terms of returns. However, HDFC Liquid has a long enough price history. So, I just picked it up. A liquid fund will be a good anchor to compare 5-year G-sec volatility against.
I would have preferred to add 10-year benchmark index for comparison but the NiftyIndices website had data only since June 2018.
Nifty 5-year GSec benchmark: CAGR of 8.44% p.a. (From September 1, 2003 until November 26, 2020).
HDFC Liquid Fund: CAGR of 7% p.a. (for the same period)
HDFC Liquid fund beats the 5-year G-Sec benchmark index in 7 years (2004, 2006, 2007, 2009, 2011, 2013, and 2017). So, something as simple as a liquid fund beats the 5-year GSec benchmark index in 7 out of 20 years.
In fact, the past decade (until 2010), the difference was not much. It is only in this decade (since 2014) when the interest rates have moved down significantly. And that has resulted in such good performance from this benchmark.
Hence, if you focus only on the past 5-year or 10-year returns (as the Motilal Oswal brochure does), you do not see the complete picture. If the interest rates show an upward trajectory in the coming decade, the tables will reverse.
Now to the rolling returns.
Just looking at the rolling returns, you can see why Motilal Oswal 5-year GSec ETF can’t be a replacement for the bank fixed deposits. Just look at the volatility.
There are long periods even in the 3-year and 5-year rolling returns when the 5-year benchmark GSec index has underperformed the HDFC Liquid fund.
Very good performance when the interest rates are going down. Struggle when the interest rates are rising.
As mentioned earlier, past 5 year or 10-year returns have been good since the interest rates have been going down. However, you can’t just look at a snapshot in time to evaluate performance.
Who should invest in Motilal Oswal 5-year G-Sec ETF?
As an investor, you must understand that Motilal Oswal 5-year GSec ETF is not a replacement for a bank fixed deposit. This ETF will be volatile and your returns experience will depend on when you invest. Your returns experience will be good during an interest rate downcycle and not as good (or even bad) during an interest rate upcycle.
SEBI categorization norms in 2017 killed short term gilt as an MF category. SEBI specified only two gilt fund categories.
- Gilt Fund (as I see, most fund managers manage the duration dynamically)
- Gilt Fund with 10-year constant duration (constant maturity of ~10 years). Expect this to be very volatile.
There was nothing left in the short to medium term gilt fund space. In my opinion, this was a gap.
If nothing else, this new ETF seems to fill that gap (would expect many other AMCs to launch similar products). Whether you should invest is a different question.
In my opinion, if you fall in up to 20% tax bracket, debt mutual funds or debt ETFs do not make a very strong case in the portfolio (in these times when the inflation is low, atleast as per Cost of inflation index. Of course, this may change). You are better off sticking with bank FDs. If you are in 30% tax bracket, then debt funds or debt ETFs come into picture.
With that premise (30% or higher income tax bracket), if you are looking for an investment (debt fund or ETF) without any credit risk for your long-term fixed income portfolio and can live with decent amount of volatility, you can consider Motilal Oswal 5-year Gsec ETF for your long term fixed income portfolio. You must have strong preference for credit risk free investment. And remember, this investment will be volatile. Can test your patience as the rolling returns data shows. Please understand my suggestion is also influenced by the dearth of simple passive GSec products in the debt fund space. With more options, my opinion may change. This 5-year GSec ETF is likely a better choice than constant maturity gilt funds.
Moreover, in my opinion, you consider this ETF for your long-term fixed income portfolio after you have exhausted your EPF and PPF options.
If you can live with some credit risk, you can just keep investing in those liquid/ultra-short/low duration/money market debt funds that invest in good credit quality securities. By the way, you can use this ETF to diversify your fixed income portfolio too.
This product is not suited for short term investments due to its volatility (as we have seen above).
Even if you must invest, I would suggest not to rush into this product right away. Suggest you follow the performance, tracking error and liquidity in the ETF counter for the next 6-12 months at least and then take a call.
Do note go by the returns of past few years. The current yield (as on October 2020) is only 5.17% p.a. Hence, do not expect fireworks unless interest rates fall further from here.
I would have preferred FoF
I would have preferred if Motilal AMC had also launched a Fund-of-Fund (FoF) that invests in this ETF (much like Edelweiss has done with Bharat Bond ETFs).
In an FoF, you buy from the AMC and redeem with the AMC. Just like any other mutual fund. You wouldn’t have to buy/sell on the stock exchanges.
That way, you would have avoided the problems around transacting in ETFs on your own. While FoF would have come at slightly higher expense ratio (there will be expense ratio of FoF + expense ratio of underlying ETF), it would have been much convenient. The FoF NAV would also have an inbuilt cost of ownership. Easy to compare performance with benchmark. ETFs will have brokerage costs etc. So, you must add transaction charges to arrive at your total cost of ownership.
It will be relatively easier to exit large investments in case of a FoF.
By the way, if you must invest in an FoF, Bharat Bond FoF remains a fine choice.
Difference between Bharat Bond ETF (or FoF) and Motilal Oswal 5-year Gsec:
- Bharat Bond ETF invests in PSU bonds (which are only quasi-sovereign). Motilal 5-year GSec ETF invest in Government securities. That’s why you can expect yields in Bharat Bond ETF/FoF to be slightly higher too.
- Bharat Bond ETFs are target maturity ETFs (have finite lives). Hence, interest rate sensitivity keeps going down with time. Motilal Oswal 5-year GSec ETF will have an infinite life. Hence, you can expect duration (rate sensitivity) to be in the similar range (3.5-4).
Do you plan to invest?