History : Exchange Traded Funds

 ETFs were launched post the 1987crash to overcome the lack of liquidity and intense program
trading in the market.
 ETFs had their genesis in 1989 with Index Participation Shares, an S&P 500 that traded on the
American Stock Exchange and the Philadelphia Stock Exchange.
 Toronto Index Participation Shares started trading on the Toronto Stock Exchange in 1990 which
tracked the TSE 35 and later the TSE 100 stocks.
 The first ETF trade on a U.S. exchange was Statestreet’s SPDR (SPY) which was introduced in
1993.
 SPY tracks S&P 500 index and is currently the most heavily traded security in the world.
 In 1998, State Street Global Advisors introduced the "Sector Spiders", which follow the nine sectors
of the S&P 500.
 Barclays, a British multinational banking and financial services company headquartered in London.
 In 2000 Barclays Global Investors put a significant effort behind the ETF marketplace
 iShares line was launched in early 2000.
 Within 5 years iShares had surpassed the assets of any other ETF competitor in the U.S. and Europe.

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Exchange Traded Funds – Introduction

Definition- An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much
like stocks or bonds. An ETF holds assets such as stocks, bonds, or futures. Institutional investors can
redeem large blocks of shares of the ETF (known as "creation units") for a "basket" of the underlying assets
or, alternatively, exchange the underlying assets for creation units. This creation and redemption of shares
enables institutions to engage in arbitrage and causes the value of the ETF to approximate the net asset
value of the underlying assets. Most ETFs track an Index, such as the Dow Jones Industrial Average or the
S&P 500.

An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be purchased
or redeemed at the end of each trading day for its net asset value, with the tradability feature of a closed-
end fund, which trades throughout the trading day at prices that may be substantially more or less than its
net asset value. Closed-end funds are not considered to be exchange-traded funds, even though they are
funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since
1999. ETFs traditionally have been Index funds, but in 2008 the U.S. Securities and Exchange Commission
began to authorize the creation of actively-managed ETFs.

U. S. Securities and Exchange Commission

Definition- Exchange-traded funds, or ETFs, are investment companies that are legally classified as open-
end companies or Unit Investment Trusts (UITs), but that differ from traditional open-end companies
and UITs in the following respects:

ETF’s do not sell individual shares directly to investors and only issue their shares in large blocks (blocks
of 50,000 shares, for example) that are known as "Creation Units." Investors generally do not purchase
Creation Units with cash. Instead, they buy Creation Units with a basket of securities that generally mirrors
the ETF’s portfolio. Those who purchase Creation Units are frequently institutions.

After purchasing a Creation Unit, an investor often splits it up and sells the individual shares on a
secondary market. This permits other investors to purchase individual shares (instead of Creation Units).

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Investors who want to sell their ETF shares have two options:

(1) they can sell individual shares to other investors on the secondary market, or
(2) They can sell the Creation Units back to the ETF. In addition, ETFs generally redeem Creation
Units by giving investors the securities that comprise the portfolio instead of cash.

So, for example, an ETF invested in the stocks contained in the Dow Jones Industrial Average (DJIA)
would give a redeeming shareholder the actual securities that constitute the DJIA instead of cash.
Because of the limited redeem ability of ETF shares, ETFs are not considered to be—and may not call
themselves—mutual funds.

How ETFs work?

ETFs are securities certificates that state legal right of ownership over part of a basket of individual stock
certificates. Several different kinds of financial firms are needed for ETFs to come into being, trade at
prices that closely match their underlying assets, and unwind when investors no longer want them. Laying
all the groundwork is the fund manager. This is the main backer behind any ETF, and they must submit a
detailed plan for how the ETF will operate to be given permission by the SEC to proceed.

In theory all that a fund manager needs to do is establish clear procedures and describe precisely the
composition of the ETF (which changes infrequently) to the other firms involved in ETF creation and
redemption. In practice, however, only the very biggest institutional money management firms with
experience in indexing tend to play this role, such as The Vanguard Group and Barclays Global Investors.
They direct pension funds with enormous baskets of stocks in markets all over the world to loan stocks
necessary for the creation process. They also create demand by lining up customers, either institutional or
retail, to buy a newly introduced ETF.

The creation of an ETF officially begins with an authorized participant, also referred to as a market maker
or specialist. Highly scrutinized for their integrity and operational competence, these middlemen assemble
the appropriate basket of stocks and send them to a specially designated custodial bank for safekeeping.
These baskets are normally quite large, sufficient to purchase 10,000 to 50,000 shares of the ETF in
question. The custodial bank doublechecks that the basket represents the requested ETF and forwards the
ETF shares on to the authorized participant. This is a so-called in-kind trade of essentially equivalent items
that does not trigger capital gains for investors.

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The custodial bank holds the basket of stocks in the fund's account for the fund manager to monitor. There
isn't too much activity in these accounts, but some cash comes into them for dividends and there are a
variety of oversight tasks to perform. Some managers have leeway to use derivatives to track an index.

This flow of individual stocks and ETF certificates goes through the Depository Trust Clearing Corp., the
same US government agency that records individual stock sales and keeps the official record of these
transactions. It records ETF transfer of title just like any stock. It provides an extra layer of assurance
against fraud.

Once the authorized participant obtains the ETF from the custodial bank, it is free to sell it into the open
market. From then on ETF shares are sold and resold freely among investors on the open market.

Redemption is simply the reverse. An authorized participant buys a large block of ETFs on the open market
and sends it to the custodial bank and in return receives back an equivalent basket of individual stocks
which are then sold on the open market or typically returned to their loanees.

What motivates each player? The fund manager takes a small portion of the fund's annual assets as their
fee, clearly stated in the prospectus available to all investors. The investors who loan stocks to make up a
basket make a small interest fee for the favor. The custodial bank makes a small portion of assets likewise,
usually paid for by the fund manager out of management fees. The authorized participant is primarily
driven by profits from the difference in price between the basket of stocks and the ETF and on part of the
bid-ask spread of the ETF itself. Whenever there is an opportunity to earn a little by buying one and selling
the other, the authorized participant will jump in.

The process might seem cumbersome but it does allow for transparency and liquidity at modest cost.
Everyone can see what goes into an ETF, investor fees are clearly laid out, investors can be confident that
they can exit at any time, and even the authorized participant's fees are guaranteed to be modest. If one
allows ETF prices to deviate from the underlying net asset value of the component stocks, another can step
in and take profit on the difference, so their competition tends to keep ETF prices very close to it
underlying Net Asset Value (value of component stocks).

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How ETFs are Traded

The trading of the ETF is based on a well-known mechanism called arbitrage. But first, let us see how one
can buy an ETF. There are two ways in which one can buy an ETF. One is through the market and the
other is through the fund house that has issued the ETF. Now for the pricing mechanism: if the demand of
the ETFs in the markets soars, the ETF would start trading at a premium from its intrinsic value, which
should be equal in proportion to the index that it is charting. This premium would make the buyers go to
the fund house where they would have to redeem their shares in the proportion held under each unit of the
ETF. Such units that are bought directly from the fund house are called "creation units". But usually the lot
size in which one can buy creation units is so high that only an authorized participant (market maker) or
institutional investors may have the wherewithal to buy these. In such case the retail investor would have to
go to the market itself to buy the units of the ETF, the decision in turn depending on the expectations of the
future price movements of the ETF. In case of redemption in the market, the seller would get paid in cash
and in case the fund units are taken to the issuer, the seller would get paid in kind that is the underlying
shares that make up the index. ETF trading also opens up the flood gates for some more complex trading
arrangements like arbitrage between the cash and futures market or simply put - short selling. But there is a
hitch as far as the Indian capital markets is concerned: "shorting" is not allowed. As a proxy, one can
borrow the units but that mechanism is not very efficient, as the cost of borrowing happens to range
between 12 to 18 per cent depending on one's creditworthiness. Given below is a chart that explains the
trading mechanism

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Advantages of ETFs

While many investors have similar outlooks, no two are exactly alike. Due to the unique structure of ETFs,
all types of investors, whether retail or institutional, long-term or short-term, can use it to their advantage
without being at a disadvantage to others. They allow long-term investors to diversify their portfolio at one
shot at low cost and insulate them from short-term trading activity due to the unique “in-kind” creation /
redemption process. They provide liquidity for investors with a shorter-term horizon as they can trade
intra-day and can have quotes near NAV during the course of trading day. As initial investment is low,
retail investors find it simple and convenient to buy / sell. They facilitate FII’s, Institutions and Mutual
Funds to have easy asset allocation, hedging, and equitising cash at a low cost. They enable arbitrageurs to
carry out arbitrage between the Cash and the Futures markets at low impact cost.

ETFs provide exposure to an index or a basket of securities that trade on the exchange like a single stock.
They offer a number of advantages over traditional open-ended index funds as follows:

1. While redemptions of Index fund units takes place at a fixed NAV price (usually end of day),
ETFs offer the convenience of intra-day purchase and sale on the Exchange, to take
advantage of the prevailing price, which is close to the actual NAV of the scheme at any point in
time. They provide investors a fund that closely tracks the performance of an index throughout
the day with the ability to buy/sell at any time, whereby trading opportunities that arise during a
day may be better utilized.
2. They are low cost. Unlike listed closed-ended funds, which trade at substantial premia or more
frequently at discounts to NAV, ETFs are structured in a manner which allows Authorized
Participants and Large Institutions to create new units and redeem outstanding units directly with
the fund, thereby ensuring that ETFs trade close to their actual NAVs.
3. ETFs are like any other index fund, wherein, subscription / redemption of units work on the
concept of exchange with underlying securities instead of cash (for large deals).
4. Since an ETF is listed on an Exchange, costs of distribution are much lower and the reach is
wider. These savings in cost are passed on to the investors in the form of lower costs. Further,
the structure helps reduce collection, disbursement and other processing charges.
5. ETFs protect long-term investors from inflows and outflows of short-term investors. This is
because the fund does not incur extra transaction cost for buying/selling the index shares due to
frequent subscriptions and redemptions.

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6. Tracking error, which is divergence between the NAV of the ETF and the underlying Index, is
generally observed to be low as compared to a normal index fund due to lower expenses and the
unique in-kind creation / redemption process.
7. ETFs are highly flexible and can be used as a tool for gaining instant exposure to the equity
markets, equitising cash or for arbitraging between the cash and futures market.
8. Tradable and Diversifiable: The ultimate selling proposition of an ETF lies in its twin feature
of being tradable and diversifiable. One can trade a stock but then it is not diversifiable. Or, one
can buy a mutual fund and thereby diversify but then the mutual fund would not be tradable.
Alternatively, one can diversify one's risks by holding a portfolio of stocks and trade them but
that would be too much of a botheration for the lay investor. These conflicts are reconciled by an
ETF that is at once tradable and is a diversified portfolio too. It is these two features, working in
tandem, like the twin blades of a scissor that make it a financial product of choice.
9. Transparency: Just like the index fund, the portfolio of an index fund has no mystery to it.
Everybody in the participating market is aware of the stocks that it is tracking and therefore need
not worry about a change in the stocks being traded in.
10. Makes multiple trading strategies possible: As has been said earlier, ETFs have the utility of
doubling up as arbitraging instruments between the futures and cash markets. It also helps in
equitizing cash, i.e., changing cash into equities, at a low cost.
11. A Bear market friend: In a volatile stock market, an ETF might become an instrument of
choice as it is not expected to be as volatile and yet may be traded. This is borne out by the fact
that the assets of US ETFs have grown from $ 96 billion in January 2003 to $118 billion in May
2003.

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The Risks

1. The performance of ETFs that track a concentrated/sector index could be more volatile than the
performance of diversified funds.
2. Like other index-tracking funds, ETF is not actively managed, meaning that the fund manager does
not have the discretion to select stocks or secure defensive positions in declining markets. Hence,
any fall in the underlying index will result in a corresponding fall in the value of the ETF.
3. There is no assurance that the performance of the ETF will be identical to the performance of the
underlying index due to factors such as tracking errors.
4. Although listed on a stock exchange, ETFs face the risk of not being actively traded, i.e. liquidity
problems.
5. The market price of the ETF unit could be higher or lower than its NAV per unit due to market
demand and supply and liquidity.
6. Absence of prior active market: In India ETFs being a new instrument, there is no existing market
that one could swim into immediately after buying the product. So for the liquidity to be reasonable,
a large number of investors would have to buy into the idea to make adequate liquidity possible.
7. Large Investments: In order to deal directly with the fund houses large capital investments are
required. For example in the case of Nifty BeES, a minimum creation unit size of 20000 units is
required that would involve lakhs of rupees in investment. This makes ETFs a market where the
institutional buyers and sellers become the big fish.
8. Broker Charges: Broker charges have to be paid anyway when trading in ETFs. This can be
minimized by trading long but the very charm of ETFs is destroyed because it is meant for being
traded more often than an index fund.
9. Premiums and discounts: An ETF might trade at a discount to the underlying shares. This means
that although the shares might be doing very well on the bourses, yet the ETF might be traded at less
than the market value of these stocks.
10. Does not facilitate "rupee cost averaging": An ETF is not appropriate for those investors who
want to operate on the strategy of "rupee cost averaging". This is because investors investing some
money into ETFs every month would have to incur brokerage costs that are not to be incurred in case
of mutual fund units until and unless the scheme carries an entry load.

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Types of Exchange Traded Fund
The following are the common types of exchange traded funds:

Index exchange traded fund

This is the most popular exchange traded fund. As evident from the name, it tracks the index performance
with the objective of replicating it. It buys every stock available in the benchmark index in equal
proportions and manages them passively, which involves lower expenditure. Some of the renowned index
funds are IDFC Nifty Fund, UTI Nifty Index Fund, HDFC Index Fund, Aditya Birla SL Index Fund, IDBI
Nifty Index Fund, SBI Nifty Index Fund, Reliance Index Fund, etc.

Stock exchange traded fund

This exchange traded fund investment offers investors the exposure to an extensive variety of equities in a
specific index or sector, without having to purchase individual stocks.

Bond exchange traded fund

This exchange traded fund category, traded on a stock exchange, aims to replicate the returns of an index of
bonds. They include exciting properties similar to that of equities. Bond exchange traded fund offer several
benefits like transparency of prices, monthly income pay-outs, diversification, high liquidity and ease of
trading.

Commodity exchange traded fund

As suggested by the name, this type of exchange traded fund invests in commodities like gold, silver and
other precious metals. Gold exchange traded funds are classified under this category of exchange traded
fund. Several commodity exchange traded funds nowadays administer the futures trading strategy.

Currency exchange traded fund

This exchange traded fund aims to seamlessly expose investors to the foreign exchange market and is
priced reasonably. It effectively tracks behaviour of a particular currency in the foreign exchange market
and streamlines processes to enable trading of currencies during the usual trading hours.

Actively Managed exchange traded fund

In this exchange traded fund, a fund manager drives decisions regarding the portfolio of the underlying
assets. Though it is not accompanied by a benchmark index, the fund managers can implement changes in
the allocations of sectors. When these exchange traded funds are actively managed, they attract a high
expense ratio.

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