ETFs (Exchange Traded Funds)

Exchange Traded Funds are essentially Index Funds that are listed and traded on exchanges like stocks. Until the development of ETFs, previously this was not possible. Globally, ETFs have opened a whole new panorama of investment opportunities for retail as well as institutional money managers. ETFs enable investors to gain broad exposure to entire stock markets in different Countries and specific sectors with relative ease, on a real-time basis and at a lower cost than many other forms of investing.

ETFs offer several advantages to investors:-

Can easily be bought / sold like any other stock on the exchange through terminals across the country.

Can be bought / sold anytime during market hours at a price close to the actual NAV of the Scheme.

No separate form filling, just a phone call to your broker, or a click through on the internet.

Ability to put limit orders.

Minimum investment is one unit.

Enjoy flexibility of a stock and diversification of an index fund.

Low expense ratio.

Arbitrage possibilities between Futures and the Cash Market.

ETFs are very popular globally with nearly 60% of trading volumes on the American Stock Exchange (AMEX) captured by ETFs. At the end of March 2008, there were over 1280 ETFs with assets of US$ 760.80 billion managed by 79 managers across 42 exchanges around the world. Among the popular ones are:-

SPDRs — The S&P 500 Depository Receipts were the first ETFs to be launched in 1993. SPDRs track the S&P 500. There are select sector SPDR funds available. These are traded on the AMEX.

Can be bought / sold anytime during market hours at a price close to the actual NAV of the Scheme.

QQQs — Popularly known as Cubes, they are listed on the NASDAQ and track the NASDAQ -100. It is one of the most liquid ETFs.

iShares — World Equity Benchmark Shares are listed on the AMEX and offer investors access to 17 foreign markets. iShares track the Morgan Stanley Capital International (MSCI) Indices.

TRAHK — Trahks is listed on the Stock of Exchange of Hong Kong and the investment objective is to provide investment results that closely correspond to the performance of the Hang Seng Index.

TRAHK — Represents an undivided beneficial ownership in common stock of a group of several companies within a specified industry. HOLDRs are unlike other ETFs, which add and drop shares depending on changes in the underlying Index. In HOLDRs, the underlying securities once pre-defined, do not change except when mergers, acquisitions or other occurrences take place that lead to the termination of the common shares of the Company.

While the Expense Ratio of ETFs is generally low, there are certain costs that are unique to ETFs. Since ETFs are bought as shares through a broker, every time an investor makes a purchase, he/she pays a brokerage commission. In addition, an investor can suffer the usual costs of trading stocks, including differences in the ask-bid spread etc. Of course, traditional Mutual Fund investors are also subjected to the same trading costs indirectly, as the Fund in turn pays for these costs.

ETFs can either be purchased on the Exchange or directly with the Fund. The Fund creates / redeems units only in predefined lot sizes in exchange for a predefined underlying portfolio basket. Once the underlying portfolio basket is deposited with the Fund together with a cash component, the investor is allotted the units.

ETFs have a very transparent portfolio holding and predefined creation basket. This allows arbitrageurs to create and redeem units every day through the in-kind creation / redemption mechanism. Such arbitrageurs are always in the market to take advantage of any significant premium or discount between the ETF market price and its NAV by doing arbitrage between the ETF and its underlying portfolio.

Thus, the open architecture of ETFs ensures that there is no significant premium or discount to NAV. At the same time, additional demand / supply is absorbed due to the action of the arbitrageurs.

ETFs derive their liquidity first from trading of the units in the secondary market and secondly through the in-kind creation / redemption process with the fund in creation unit size.

Due to the unique in-kind creation / redemption process of ETFs, the liquidity of an ETF is actually the liquidity of the underlying shares.

ETF versus normal open-ended mutual funds?

Buying / selling ETFs is as simple as buying / selling any other stock on the exchange.

ETFs allow investors to benefit from intraday movements in the market, which is not possible with open-ended Funds.

ETFs have lower management fees. As ETFs are listed on the Exchange, distribution and other operational expenses are significantly lower, making it cost effective. These savings in cost are passed on to the investor

ETFs have lower tracking error due to in-kind creation and redemption.

Due to its unique structure, the long-term investors are insulated from short term trading in the fund.

Though close-ended mutual funds are listed on the exchange they have a limited number of shares and trade at substantial premiums or more often at discounts to the actual NAV of the scheme. Also, they lack the transparency, as one does not know the constitution and value of the underlying portfolio on a daily basis.

With ETFs, the numbers of units issued are not limited and can be created / redeemed throughout the day. ETFs rely on market makers and arbitrageurs to maintain liquidity so as to keep the price in line with the actual NAV.

Comparison of ETFs with open ended funds and close ended funds: