Exchange Traded Funds (ETFs) have been in existence in India for quite some time now.

Apart from Benchmark AMC, which specializes in ETFs, there have been a couple of ETFs from Prudential ICICI AMC and UTI AMC. But so far ETFs have not enjoyed the kind of popularity that the conventional Mutual Funds enjoy. One reason could be the lack of understanding of the concept of ETF amongst the general investor. (Also read - Should one invest in Index Funds?) Second, and probably the more important reason, is that ETFs by nature track a certain index (e.g. Nifty or the Bankex). Hence, the returns one can expect from ETFs will be equal to the rise in the index. Whereas, India is a growing market and hence offers huge opportunities in the non-index shares too. Therefore, it is not difficult for an active fund manager to beat the index and offer better returns. As such ETFs (and index-funds too, by that logic) have comparatively negligible AUMs. Two things could, however, make ETFs popular in India One, of course, is that as market valuations become fairly or over-valued, it will become more & more difficult to beat the index. Then index-based funds (both conventional MFs & ETFs) may become a better option than actively-managed funds Gold ETFs or Real-Estate ETFs have no comparable product in the conventional MF sector, and hence become the only MF route to invest in such markets

Heres an interesting live example. About 1-2 years ago the banking sector was not very popular. But with the rise in interest rates and the general economic growth, bank stocks were becoming quite popular. As a result the only banking index fund viz. Benchmark AMCs the Banking BeES (there are few banking sector funds but not bank-index funds) saw a jump of AUM from about Rs.370 crores in June 2005 to almost Rs.7,400 crores by December 2006. This makes it the largest MF scheme, much higher than about Rs.5000 crores Reliance Equity Fund. (Also read - How to profit from Mutual Funds?) What are ETFs? How are they different for a normal MF? Are they worth investing? We look at the answers to these and some other common queries regarding the ETFs. What are ETFs? As the name suggests, ETFs are a mix of a stock and a MF in the sense that

Like mutual funds they comprise a set of specified stocks e.g. an index like commodity e.g. gold; and Like equity shares they are traded on the stock exchange on real-time basis.

Nifty/Sensex

or a

How does an ETF work? In a normal fund we buy/sell units directly from/to the AMC. First the money is collected from the investors to form the corpus. The fund manager then uses this corpus to build and manage the appropriate portfolio. When you want to redeem your units, a part of the portfolio is sold and you get paid for your units. The units in a conventional MF are, therefore, called in-cash units. But in ETF, we have something called the authorized participants (appointed by the AMC). They will first deposit all the shares that comprise the index (or the gold in case of Gold ETF) with the AMC and receive what is called the creation units from the AMC. Since these units are created by depositing underlying shares/gold, they are called in-kind units. (View - New Fund Offers open NOW) These creation units are a large block, which are then split into small units and accordingly bought/sold in the open market on the stock exchange by these authorized participants. Therefore, technically every buy and sell need not change the corpus of an ETF unlike a conventional MF. However, as and when there is more demand, these authorized participants deposit more shares with the AMC and get more creation units to satisfy the demand. Or if there is more redemption, then they give back these creation units to the AMC, take back their shares, sell them in the market and pay the investor. (Also read - How to make money in a volatile market?)

All this may seem to be a bit complicated and time-consuming. But, in effect, it is all system driven and hence happens on real-time basis with minimal effort & cost. Comparison with conventional MFs Let us now look at how similar & dissimilar the ETFs are vis--vis the conventional MFs.

1. Since all ETFs require certain specific shares to be deposited for units to be created, they all are
usually index-specific like Nifty, Sensex, Bankex etc. As against this, a conventional MF can have any portfolio (though as per the pre-defined objective). Of course index funds will also mimic the index and hence to that extent ETFs & index funds are same 2. Because ETFs are index-specific, the portfolio remains more or less constant, whereas portfolio of an actively managed conventional MF will change on day-to-day basis. Hence, while portfolio of ETF is known beforehand, the portfolio of a conventional MF can be known only at the time of month-end disclosures.

3. ETFs are bought/sold on the stock exchange and need a demat account. Conventional MFs are
bought/sold from/to the AMC. 4. ETFs can be traded like a stock at any time of the day and at real-time prices, while the market is open. Whereas, one can buy MFs only at the NAV based on the closing prices. 5. The unit capital of close-ended funds (and even shares) will not change with trading. But unit capital of ETF can change with trading and hence to that extent they behave like open-ended funds 6. There are some close-ended funds listed on the exchange. But because they are structurally different from an ETF, they can trade at substantial discount (or premium) to the NAV. This will not be the case with ETFs. 7. Like conventional MFs, they offer the benefits of diversification 8. As financial instruments per se, ETFs are as safe as conventional MFs. But, of course, the market risk remains. 9. In ETF, AMCs need not keep a large portion in cash to meet redemption pressures 10. Also, unless there is a huge redemption pressure, shares need not be sold to generate cash to meet the redemptions the normal buying & selling of units amongst the investors will take care of day-to-day redemptions. To that extent, ETFs are somewhat protected 11. In ETF each investor pays his share of costs, unlike conventional MFs where costs are deducted from the NAV on an average basis. As such the long-term investors suffer, while short-term investors end-up paying lesser costs in conventional MFs. Benefits of investing in ETFs Convenient to trade as it can be bought/sold on the stock exchange at any time of the day when the market is open (index funds can be bought only at NAV based on closing prices) One can short sell an ETF or buy on margin or even purchase one unit, which is not possible with index-funds/conventional MFs ETFs are passively managed, have low distribution costs and minimal administrative charges. Hence most ETFs have lower expense ratios than conventional MFs Not dependent on the fund manager Like an index fund, they are very transparent SIP in ETF is not convenient as you have to place a fresh order every month Also SIP may prove expensive as compared to a no-load, low-expense index funds as you have to pay brokerage every time you buy & sell Because ETFs are conveniently tradable, people tend to trade more in ETFs as compared to conventional funds. This unnecessarily pushes up the costs.

Disadvantages of investing in ETFs

You cant automatically re-invest your dividends. Secondly, you may have to pay brokerage to reinvest dividends in ETF, whereas dividend reinvestment in MFs is automatic and with no entry-load Comparatively lower liquidity as the market has still not caught up on the concept

It may, therefore, be concluded that if an investor is looking for a long-term and defensive investment strategy in equities by backing the index rather than looking at active management, ETF offers an alternative to index-based funds. It offers trading convenience & probably lower costs than index funds. A case-to-case comparison is, however, important as some index-funds may be cheaper. Also for SIPs, index-funds may prove better than ETFs. However, in the absence of conventional MFs like in Gold, ETFs is but a natural and better choice than buying/selling physical gold.

ETFs (Exchange Traded Funds) What are ETFs? Exchange Traded Funds are essentially Index Funds that are listed and traded on exchanges like stocks. Until the development of ETFs, this was not possible before. Globally, ETFs have opened a whole new panorama of investment opportunities to Retail as well as Institutional Money Managers. They 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. An ETF is a basket of stocks that reflects the composition of an Index, like S&P CNX Nifty or BSE Sensex. The ETFs trading value is based on the net asset value of the underlying stocks that it represents. Think of it as a Mutual Fund that you can buy and sell in real-time at a price that changes throughout the day. What are benefits of ETFs? 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 on the net. Ability to put limit orders. Minimum investment is one unit. Enjoy flexibility of a stock and diversification of index fund. Expense Ratio is lower.

Provides arbitrage between Futures and Cash Market. Are ETFs popular worldwide? ETFs are very popular abroad 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 in the market 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 unless due to mergers, acquisitions or other occurrences that lead to the termination of the common shares of the Company. What are the costs of investing in ETFs through the exchange? While the Expense Ratio of ETFs is generally low, there are certain costs that are unique to ETFs. Since ETFs, like stocks, 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. How does the in-kind creation / redemption mechanism work in ETFs? 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. This is in-kind creation / redemption of units, unique to ETFs. Alternatively, investors can follow the "Cash Subscription" route in which they can pay cash directly to the Fund for purchasing the underlying portfolio. Why do ETFs trade close to their NAV? 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. How do ETFs derive their liquidity? ETFs derive their liquidity first from trading of the units in the Secondary Market and second 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 in the underlying shares. What are the advantages of ETFs over normal open-ended mutual fund? Buying / Selling ETFs is as simple as buying / selling any other stock on the exchange. ETFs allow investors to take benefit of intraday movements in the market, which is not possible with open-ended Funds. With ETFs one pays 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. What are the differences between ETFs and close-ended mutual funds? 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. In ETFs, the number 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 v/s Open Ended Funds v/s Close Ended Funds: Fund Size NAV Liquidity Provider Availability Portfolio Disclosure Open Ended Fund Flexible Daily Fund Itself Fund Itself Disclosed monthly Closed Ended Fund Fixed Daily Stock Market Through Exchange where listed Disclosed monthly Exchange Traded Fund Flexible Real-Time Stock Market / Fund Itself Through Exchange where listed / Fund itself. Daily/Real-time

Intra-Day Trading

Not possible

Expensive

Possible at low cost

For whom are ETFs suitable ? A broad class of investors can use ETFs: The major players in this market have historically been Large Institutional players seeking to Index core holdings or pursue more aggressive market timing and sector rotation strategies. However, since Smaller Institutions and Retail Investors can trade in small lots, they can invest in essentially the same terms as Large Investors. For Retail or Wholesale Investors with a long-term horizon, it allows diversification of portfolio with one single investment. It insulates them from short term trading activity of other investors in the Fund as ETFs have a unique in-kind creation / redemption mechanism. Lower costs of ETFs enhance net returns in the long term. For FIIs, Institutions and Mutual Funds, it allows easy Asset Allocation, Hedging and Equitising Cash at a low cost. For Arbitrageurs, it provides ease with low Impact Cost to carry out arbitrage between the Cash and the Futures market. For investors with a shorter term horizon, ETFs provides access to liquidity due to the ability to trade during the day and at values near to NAV. What are the USES OF ETFs? Asset Allocation : Asset allocation managing could be difficult for individual investors given the costs and assets required to achieve proper levels of diversification. ETFs provide investors with exposure to broad segments of the equity markets. They cover a range of style and size spectrums, enabling investors to build customized investment portfolios consistent with their financial needs, risk tolerance, and investment horizon. Both institutional and individual investors use ETFs to conveniently, efficiently, and cost effectively allocate their assets. Cash Equitisation : Investors typically seek exposure to equity markets, but often need time to make investment decisions. ETFs provide a "Parking Place" for cash that is designated for equity investment. Because ETFs are liquid, investors can participate in the market while deciding where to invest the funds for the longer-term, thus avoiding potential opportunity costs. Historically, investors have relied heavily on derivatives to achieve temporary exposure. However, derivatives are not always a practical solution. The large denomination of most derivative contracts can preclude investors, both Institutional and Individual, from using them to gain market exposure. In this case and in those where derivative use may be restricted, ETFs are a practical alternative. Hedging Risks : ETFs are an excellent hedging vehicle because they can be borrowed and sold short. The smaller denominations in which ETFs trade relative to most derivative contracts provides a more accurate risk exposure match, particularly for small investment portfolios. Arbitrage (Cash Vs Futures) and Covered Option Strategies: ETFs can be used to arbitrage between Cash and Futures Market, as it is very easy to trade. ETFs can also be used for cover Option strategies on the Index. What happens to dividends? Dividends received by the Scheme will be reinvested in the scheme. However, the Fund may

also decide to distribute dividends to the investors. What are the rules governing taxation of ETFs? Same rules apply as in the case of buying or selling stocks or mutual fund units. Kindly refer the respective Offer Document /Key Information Memorandum What happens if constituents in the underlying index change? Constituents of an Index are changed as and when Securities in the Index do not match specific criteria laid down by the Index Service Provider or a better candidate is available to replace a constituent. The Index Service Provider usually makes announcements of change well in advance. Once Securities in the underlying index are changed, the Fund would change the Securities in its underlying portfolio by selling the Securities that are being removed from the Index and including those that are included in the Index. This will in no way affect the units being held by an investor, as the units will continue to track the index. The only effect may be on the tracking error of the scheme. Index changes are usually not so frequent. In India, historically, around 10%of the Index constituents have changed annually which means an index of 50 securities would experience about 5 changes every year. How do ETFs compare with Index Futures? Index Futures have gained wide acceptance globally as a tradeable means of shifting exposure to Indices. Index Futures are advantageous when the implied Cost of Carry is less than the actual Cost of Carry. In addition, an investment in ETFs requires investment of the entire notional value, while an investment in Futures requires posting of an initial collateral deposit and then daily Market to Market Margins which represent a small fraction of the notional value, allowing leverage. ETFs are beneficial over Index Futures in many situations: When investors cannot or prefer not to trade Index Futures When cash flows are small and investors do not have For longer-term horizons, Index Futures need to be rolled over every month /quarter which has its own risk and costs If regulations prevent investors from investing in Futures; Taxation issues: With Index Futures investors can avail of only short-term capital gains while with ETFs, investors can avail long-term capital gains. If the discount in ETFs is greater than the discount in futures