With the world changing right before our eyes, emerging market countries due to sharp technological changes coupled with economic reforms are rapidly closing the gap with the west. Emerging markets need to be at the core of any global investment strategy because with proper risk management these are the markets which will give greater returns than the already developed markets.

Being built on sound corporate governance principles: Board of Directors, Compensated management, highly detailed record keeping and audit requirements and regulated by the exchange commissions, ETFs can hold any type of asset, including stocks, bonds, futures, currencies, or even tangible commodities such as gold bars. This feature provides ETF investors exposure to broad array of stocks, commodities and several other investment classes that may otherwise be unreasonable. With simple execution, investing flexibility and transferability, ETFs also provide tax benefits and cost effectiveness when compared to other instruments such as mutual funds. Created with the purpose of mimicking the concerned market, ETFs provide the flexibility of buying even one unit and trading it throughout the market hours. Thus, although the ETFs have some disadvantages of its own, they are still very good options to hedge risk and create investment opportunities.

Introduction

In today’s world of high risk-high return investments, the product class of Exchange Traded Funds, or ETFs as they are commonly known, stands out from the crowd as a shining example of an avenue of investment having relatively less risk and market-matching returns. ETFs comprise of a basket of securities – equity, commodities, exotic instruments etc- which are bundled together to form ‘creation units’, which are then traded on an exchange, just like any equity stock. In simple words, an ETF is like a Mutual Fund which trades on a stock exchange. It aims to track its native index as closely as possible. After a dodgy start in 1989, ETFs were formally launched in 1993 and since then have come a long way. The US markets ETFs alone have more than $900 Billion in assets.

ETFs have been attracting interest because they are seen by some as the future of the Mutual Fund industry. Their benefits over the currently preferred Mutual Funds in terms of tax savings and risk diversification will soon make mutual funds a preserve of those who prefer riskier investments.

The purpose of this paper is to look into the benefits of an ETF and why ETF is the call of the future. It describes the construction and classification of ETFs and how ETFs use “redemption in kind” to avoid taxes and thus get an advantage over MFs. It also compares and analyses the returns on an ETF compared to an index fund and the index itself to prove the benefits of an ETF.

Exchange Traded Fund – Definition

ETFs are a special class of ‘Open End’ funds with some characteristics of closed end funds. They are easy to trade because they are listed on the stock exchange and like shares of different companies, they also trade. Just like the shares of different firms, investors can trade them during market hours and can bought, shorted and margined. ETFs are usually used to track a specific index and thus they represent a portfolio which has the ability to mimic the required index’s performance. ETFs can be created for different indices of developed countries (moderate risk/ return) or for emerging countries (high risk/ return). ETFs can be a source of diversification mitigating international risks. ETFs present in the market are offered by several participants including AMCs, financial institutions etc.

Benefits

The rise and rise of ETFs is due to the manifold benefits that it purports to have.

Diversification:  One of the main benefits of trading ETFs is diversification.  ETFs were created to track an index, be that a stock index, commodity index, currency index, or almost any other type of security index.  The advantage of trading an index is that you are shielded from the volatile up and down swings of a given individual security.

Also to provide even more variety, there are ETFs which may track only a given sectorial index of a particular capital market like Kotak PSU Bank ETF which tracks the CNX PSU Bank Index.

ADVANTAGES OVER MUTUAL FUNDS:

TAX ADVANTAGES: The prime benefit of preferring an ETF over a Mutual Fund is the reduction in tax liabilities due to very few cash transactions. Removal of cash from transactions has eliminated capital gains tax from the picture. A major portion of the difference between pre-tax and after-tax returns of a mutual fund is because of Capital Gains Tax, which is absent in the case of ETFs. This is primarily because when investors redeem their shares; in case of MFs they get cash, which is taxed; whereas while redeeming ETF an investor gets back some of the underlying shares.

LOW TRANSACTION COSTS: ETFs have much lesser transaction costs as compared to mutual funds. This is because generally, ETFs have an average holding period which is longer than that of a Mutual Fund. This means that it pays less brokerage. Mutual Funds also cost more because it involves a lot of people – fund managers, salesmen, researchers etc – who must be paid, while ETF portfolios are generally decided electronically and don’t involve too much manpower. Even the Vanguard Index 500 Fund, known for its no-frills and low cost, has a transaction fee of 18 basis points, which is far higher than SPDR 500 ETF, which charges only 10 basis points.

LIQUIDITY: Since the ETFs trade like a normal equity on a capital market and there is a sufficiently large volume which is traded throughout the day, ETFs are very much liquid and can be sold on wish.

LOWER ‘CASH DRAG’: ETFs don’t have to maintain cash balances to take care of redemption pressures, they simply return the securities. However, mutual funds have to maintain cash balances, thereby reducing the amount available for investment. This reduces their returns. This reduction in returns due to holding liquid cash is called ‘cash drag’.

Other benefits are lower ‘style bias’, or mismatch between stated objective and actual holdings, real time adjustments in Intra-day Portfolio Value (IPV), giving sharp investors the advantage, and higher holding transparency, as ETFs report their holdings daily, while Mutual Funds report only twice per year.

ETFs – Working

Creation

Creation of an ETF involves a fund manager (“sponsor”) obtaining the necessary regulations and then tying up with an “authorised participant”, a market maker or a specialist who is empowered to create and redeem ETF shares. The authorised participant buys or borrows a multitude of shares belonging to an index / category and places them in a trust. The ETF generally mimics an index and therefore, the shares are bought in the same weights as that in the index. The shares are used to make ‘creation unit’, each of which contain a large number of shares, upwards of 50,000 shares generally. In turn, the shares of the ETF are made available to the participant, who then sells it to the general public. Each share represents a claim to the pool of assets held by the trust and the market for ETFs work just like the equity market.

Daily Working

Being a fund, each share of the ETF has a value called the Net Asset Value (NAV) which the ETF reflects the value of the underlying securities and generally doesn’t fluctuate too much. This is given out at the end of each day. However, since the ETF shares trade just like common equity shares, there needs to be a price which responds to the forces of demand-supply and the change in value of underlying securities instantaneously. This value is called IPV. Generally, there is very little difference between the NAV and the IPV.

In case there is a high deviation, arbitrageurs come in the play. If the NAV is lesser than the intrinsic value of the securities, the arbitrageurs buy ETF shares, redeem them and sell the underlying securities and vice versa. Thus, the forces of demand and supply bring back equilibrium in the market.

Redemption

ETF shares can be redeemed by way of cash or in-kind. This is done by selling the shares in the open market and obtaining cash, a route generally followed by retail investors.

However, the institutional investors, with strong financial muscle, generally use the ‘redemption in kind’ method to take advantage of tax benefits. In this method, the Institutions buy large swathes of shares, enough to make a creation unit. They return this creation unit to the trust and get the underlying securities. Since there is no cash transaction, therefore there is no capital gains tax. Also, the ETFs give the shares which have the lowest cost base, thus increasing their average cost base reducing their future tax liabilities. This can result in substantial tax savings.

Types

Apart from ETFs composed of equity stocks which track indexes, there are also other types of ETFs. They either track equity performance in a particular sector or focus on fixed income market or the commodities markets etc.

Commodity ETFs

They are instruments which track the performance of the underlying commodity index like Oil ETFs, Gold ETFs, Energy ETFs etc. However, the return patterns are more complicated as the underlying asset is not equity but future contracts, which are rolled over. Thus, an increase in the commodity prices doesn’t necessarily result in linear profits from the ETF. Table (1) shows the benefits a commodity ETF such as of Gold has over the original metal.

Bond ETF

These ETFs try to replicate a correlating index or some underlying fixed-income instruments. Though the bonds universe is very vast, a major issue here is that bonds are not very liquid whereas ETFs have to provide high liquidity. The work-around is that a bond ETF usually consists of only the largest and most liquid bonds in the underlying bond index. This gives the bond ETF the ability to emulate the index and be more “trader friendly” at the same time.

Bond ETFs also pay out an interest with a monthly dividend, even though capital gains are paid out on an annual basis. And while that does give bond funds the same tax advantages as traditional ETFs, it doesn’t play as big a role in bond ETFs because bond returns are not as heavily impacted by capital gains as stocks are. Also, although they have relatively lesser returns in general, they provide the assurance of a steady stream of income and generally thrive in economic recessions, unlike equity ETFs, thus decreasing the overall portfolio volatility.

Currency ETF (ETC)

Currency ETFs, as the name suggests, invest in a basket of currencies to hedge risks against movement of the home country currency. It is more beneficial for institutional investors who move in and out of asset classes and hence can reap benefits of a possible profit situation. Retail investors, who do not follow the markets closely and are not very well educated, may not benefit as much.

Exchange-Traded Grantor Trusts

They are similar to ETFs but differ in one major respect, the investor directly owns the underlying shares/securities and derives benefits out of it unlike ETFs where the investor just has a claim on the underlying asset. Thus, in an ETGT, the investor gets dividends, voting rights etc. Also, the investment is fixed and can’t be changed over time unlike ETFs. This leads to low costs but reduces options for diversification in case of change of objectives of the investor.

Leveraged ETFs

They are ETFs which try and provide 2x or 3x times the return on its underlying index on a daily basis. This is done by holding not only stock but also derivatives like forwards, options etc. This makes the investment riskier and prone to ‘tracking error’.

Inverse Leveraged ETFs

This category of leveraged ETF actually tries to replicate the inverse of what the index is returning. So if index is giving negative returns, the inverse leveraged ETFs will give positive returns.

There are other types also like Microcap, Style, Dividend, Regional, Emerging fields etc.

PERFORMANCE Analysis and Results

To determine the best possible investment choice from among the various options viz. Mutual Funds, Index Funds, ETFs and Stocks/ commodities, we compare and analyse these options based on various parameters. The situation in India is first analysed and is then compared with international markets.

Expense Ratios

Expense ratio is a measure of the cost of operations of a fund and is calculated by dividing the operating expenses with the average total Assets Under Management (AUM).The expense ratios clearly prove that mutual funds are a very inefficient way of investment as a large portion of returns is used up as ‘fund managing expenses’. Also, since Index fund is also a mutual fund which actively participates in the market, it has higher managing costs than ETFs. Thus, referring to Table (2) data, ETFs clearly emerge the winners in this parameter, as lesser the expense ratio; more will be the returns available for the investor.

Returns

Table (3) reveals that ETFs and Index funds both have similar returns. In fact, the ETF has outperformed Franklin Templeton India Index Fund (FTIIF) by 0.53% in the last 1 year. However, FTIIF pips ETFs’ return over the last 6 months by 0.16%. Returns from mutual funds vary from one fund to another. These returns are, however, pre-tax returns. Gains from these investments, whether short term or long term, are taxed by the government, either at the hands of the fund or at the hands of the investor. ETFs are the only exception to this case, as redemption of ETF shares lead to exchange of similar securities and therefore are exempt from Capital Gains Tax.

Furthermore, by giving the investor, the shares with the lowest cost base, the ETF can keep its average cost base higher, thereby reducing its tax liability ensuring that more money is available to distribute amongst the investors.

The outperformance of the ETF over the Sensex can be explained only by the forces of demand and supply. Indian markets, being a developing one, still have a lot of activity based on sentiments rather than on concrete information. The bullish sentiment led to people pre-emptively buying ETF shares thereby raising its prices. This is how the ETF has managed to outperform the market by 0.29% over the last 6 months. In fact, the effect of this positive sentiment is so strong that has managed to overcome the negatives of an ETF as pointed out by Elton, Gruber, Comer and Li (2000) — expense costs and delayed reinvestment of dividends.

The outperformance of Index funds over the market is explained by a positive ‘tracking error’ that the fund might have. This has probably led to returns higher than market.

In the commodities market, the ETF being analysed, Kotak Gold ETF, has managed to almost mirror the returns that can be obtained by investing in gold directly. Kotak Gold ETF has given a return of 15.52% last year as compared the 16.58% return that could have been obtained by investing in gold. The minor difference can be attributed to expense cost and slight tracking errors. Single commodity ETFs have relatively less tracking error as compared to equity index ETFs due to less number of items to follow. A part of lower returns may also be because of the costs of holding physical gold. Thus Gold ETFs, and thereby commodity ETFs, are a smart idea to invest because the level of transparency is very high. The dematerialised form and the avoidance of wealth tax are other benefits.

In fully developed equity markets like US, the ETFs and index funds show very similar returns (Table (5)) both of which are slightly lower than the markets. As should theoretically be the case, ETFs don’t outperform the index as investors are relatively more rational there and irrational exuberance doesn’t drive up the IPV of ETFs. The tracking errors of both ETFs and Index funds are lower in US, mainly because ETFs have been around for a long time there and the players have mastered the art of controlling costs, unlike India where ETFs are a relatively new phenomenon.

Conclusion

ETFs seem to offer the benefits of both open-end and closed-end mutual funds. The chief characteristics of ETFs are that they trade at close to net asset value and that, like closed-end funds, they offer the ability to transact at the market price at any point during the trading day. They avoid the disadvantages of closed-end funds, for which prices deviate widely from NAV. This is done by actively creating or redeeming ETF shares ‘in-kind’. They are also better off than open-end funds as they avoid the problems arising out of pricing only once a day, and, in addition, often having restrictions or minimum limits on sales and purchases by customers. This is done by trading ETF shares not at NAV but at IPV rates.

The outperformance of markets by ETF is explained by irrational exuberance shown by market participants and doesn’t last long. If sentiments didn’t play a major role, as in the international developed equity markets, the ETFs show a slightly lower return than the underlying index, primarily due to non-reinvestment of dividend income and due to management expenses.

Commodity ETF returns are slightly lower due to tracking errors and expenses which can’t be avoided. However, even in commodities ETFs have the advantage of being tradable in much smaller units, and do not require margin maintenance etc, as compared to commodity futures. This allows smaller investors to be a part of the commodity bandwagon.

The difference between the returns of an Index Fund and an ETF exist due to a multitude of reasons. However, ETFs are still a better option for people wanting to hedge risks and indulge in short term trading.

With the Exchange-Traded Funds market evolving, the new generation of funds are eliminating the disadvantages of the previous generation. Actively managed ETFs have sprung up which change their portfolios on a more frequent basis leading to higher tracking errors. Also, advent of leveraged and inverse leveraged funds have added to the risk and increased the complexity and opacity of ETFs, taking away some of the advantages. Increasing complexity may undermine the growth of the ETF market and the investors will lose out on a safe and sound investment option.

All in all, with the growth of ETFs, soon only the risk taking investors or investors with specific objectives will invest in mutual funds. ETFs have a clear edge over mutual funds, both in terms of risk-return ratio and in terms of tax benefits. Index funds are a good alternative but suffer from the some of the disadvantages of a mutual fund. ETFs, however, are free from such problems are therefore are a very good investment option.