EXCHANGE TRADED FUND

What are ETFs?

• ETFs are a basket of securities that are

listed and traded on a recognized stock
exchange.
• They are mutual funds, whose units can
be bought and sold on the stock
exchange.
• ETFs can be either passively managed or
actively managed.
 CONTI…
• In a survey of investment professionals
conducted in March 2008, 67% called ETFs the
most innovative investment vehicle of the last
two decades and 60% reported that ETFs have
fundamentally changed the way they construct
investment portfolios.
 Types of ETF
• A passively managed ETF attempts
– To replicate the performance of its underlying benchmark index
(like the S&P CNX Nifty, for instance).
– It invests in the same stocks as the index and in the same
weightage as well.
– The intention is to track the index as closely as possible (i.e. with
least deviation).
• An actively managed ETF
– Can freely invest in stocks/securities, within the guidelines laid
down by its investment mandate.
– In other words, the fund has no obligation to invest in the same
stocks/securities as its benchmark index.
– The intention is to outperform the benchmark index.
 Conti…
• Index ETFs
• Commodity ETFs
• Currency ETFs
• Exchange-traded grantor trusts
– An exchange-traded grantor trust share represents a direct interest in a
static basket of stocks selected from a particular industry. The leading
example is Holding Company Depositary Receipts, or HOLDRS, a
proprietary Merrill Lynch product.
 ETFs in India
• ETFs first made their presence felt in India in the year
1994 with the launch of Morgan Stanley Growth Fund, a
close-ended, actively managed, diversified equity fund.
• Things changed after the launch of Nifty Benchmark
Exchange Traded Scheme-Nifty BeES (launched in
December 2001), an open-ended, passively managed
fund.
• The fund set the records straight for ETFs in the country.
Since then, the ETF segment has grown slowly but
steadily.
• The launch of gold ETFs has provided the much needed
zing to the segment, thus attracting many investors.
 Conti…
• ETFs at present have a fair variety to offer.
– For example, among others, there are ETFs like
Quantum Index Fund and ICICI SPIcE Fund that track
broad indices such as the S&P CNX Nifty and the
BSE Sensex respectively.
– Then there is Bank BeES (from Benchmark Mutual
Fund), an ETF that tracks CNX Bank Index.
– On the debt side, there is Liquid BeES that invests in
a basket of call money, short-term government
securities and money market instruments.
 How ETFs function
• Given that an ETF is traded on the stock exchange, its
price may not necessarily be the same as the NAV of the
underlying portfolio.
• In other words, an ETF could have an NAV distinct from
its market price. The reason being that the market price
is usually driven by the demand and supply of units.
Hence there is a distinct possibility of an ETF’s units
trading at a premium or discount to its NAV.
• Unlike regular mutual funds, where the investor deals
directly with the AMC (asset management company), in
case of ETFs, a bulk of the buying and selling is done
over the stock exchange.
• Direct dealing with the AMC is possible only if the
transaction is done in specified lot sizes known as
‘creation units’.
 Conti….
• AMCs attempt to keep the market price of the ETF close to its NAV;
for this purpose, they appoint institutions commonly referred to as
market makers.
• These market makers try to benefit from any premium or discount
between the ETF’s market price and its NAV, by performing an
arbitrage between the ETF and its underlying portfolio.
• So how does this mechanism work?
– If an ETF is trading at a discount to its NAV, then the market maker will
buy ETF units from the stock market and then sell the same to the AMC
(in creation units); after taking delivery of the underlying stocks, the
market maker will sell the same in the stock markets, thereby benefiting
from the arbitrage opportunity. The converse will be done when an ETF
is trading at a premium to its NAV. The arbitrage mechanism helps to
keep the market price of an ETF close to its NAV
 Advantages of ETFs
• ETFs tend to be more cost-effective vis-à-vis
comparable mutual funds.
• Another important advantage with ETFs is that they
provide more flexibility to investors than regular
mutual funds.
• Since ETFs witness most of the buying/selling on the
exchange, the interests of the long-term investor are
not compromised.
• With an ETF, since the trading investor does not
approach the AMC at all and only interacts with other
investors over the exchange, his quick entry/exit does not
compromise the interests of the long-term investor.
• ETFs are traded on the stock exchange, and can be
bought/sold on a real time basis; they tend to have low
tracking error (deviation of ETF's performance from that
of the underlying index) as compared to index funds.
 Conti…
• Tax efficiency –
– ETFs generally generate relatively low capital gains, because
they typically have low turnover of their portfolio securities.

• Transparency-
– ETFs, whether index funds or actively managed, have
transparent portfolios and are priced at frequent intervals
throughout the trading day.
 Disadvantages of ETF
• Investors need to have a demat and a trading
account, with a SEBI registered stockbroker, for
investing in ETFs.
• While investors have to incur entry/exit loads at the time
of making/redeeming investments in mutual funds, for
ETFs they have to pay a brokerage (usually around
0.50%) to the stockbroker, along with other applicable
charges (STT for instance), every time ETF units are
bought or sold. For a trader who frequently trades, this
can have a significant impact on the net returns. But for
long-term investors, these expenses hold little relevance.
Thank YOU