The Chartered Accountant 699
November 2005
T H EME
Exchange Traded Funds
The latest innovations
in the Indian finan-
cial market have been
the Exchange Traded Funds
(ETFs). They are the new
species of the financial in-
struments market and have
become the buzzword in the
volatile Indian stock markets.
However, in the internation-
al markets we come across
many such ETFs such as VI-
PERS, SPIDERS, WEBS,
DIAMONDS, CUBES, etc.
VIPERS stands for Van-
guard
Index Participation
Receipts, SPDRs is Standard
& Poors Depository Receipts,
pronounced
“SPIDERS”,
CUBES is the name given for
QQQ (called so because of
its three ‘Q’s), and tracks the
technology-laden NASDAQ
100 stocks. ETFs are a novelty
only in India. Exchange Trad-
ed Funds have been in vogue
in the global financial markets,
especially the US financial
markets for a long time. An
index of their popularity can
be gauged from the fact that
about 60 per cent of the trad-
ing volumes on the American
Stock Exchange comes from
ETFs. It is only now that
these funds are catching on
in the domestic mutual fund
market in India. The first ETF
in India, “Nifty BeES (Nifty
Benchmark Exchange Traded
Scheme)” based on S&P CNX
Nifty, was launched in January
2002 by Benchmark Mutual
Fund. UTI has launched its
own ETF called SUNDERS
(S&P CNX Nifty UTI No-
tional Depository Receipts
Scheme), after Benchmark’s
BeES like Liquid BeES, Nifty
BeES, Junior Nifty BeES and
Bank BeES.
The Concept
ETFs are index tracking
open ended registered funds
or unit investment trusts that
invest in a portfolio of stocks
designed to track the perfor-
mance and dividend yield of
a specific index. They are es-
sentially mutual fund schemes
or index funds that are listed
and traded on exchanges like
stocks. Due to this they of-
fer the benefit of trading like
a stock. They are priced con-
tinually and can be bought or
sold throughout the trading
day.
An Exchange Traded
Fund, as the name itself sug-
gests; is a financial instrument,
tradable on a stock exchange
that invests in the stocks of
an index in approximately the
same proportion as held in
the index. An ETF is a hy-
brid financial product, a cross
between a stock and a mutual
fund. Like a stock it can be
traded on a stock exchange,
and like a mutual fund it be-
haves like a diversified portfo-
lio. In many ways it is an index
fund, with a few subtleties that
put it in a separate league. Un-
like an open-ended index fund,
where an investor purchases
units from the fund itself and
An ETF is a hybrid financial product, a cross between
a stock and a mutual fund. Like a stock, it can be traded on
a stock exchange, and like a mutual fund it behaves like a
diversified portfolio. In many ways it is an index fund, with
a few subtleties that put it in a separate league. Unlike an
open-ended index fund, where an investor purchases units
from the fund itself and to redeem them sells the units back
to the fund and thereby expanding or shrinking its corpus on
each entry or exit from the fund, in an ETF, it is listed on an
exchange ensuring that the entry or exit of investors has no
effect on the fund corpus.
to redeem them sells the units
back to the fund and thereby
expanding or shrinking its
corpus on each entry or exit
from the fund, in an ETF, it is
listed on an exchange ensuring
that the entry or exit of inves-
tors has no effect on the fund
corpus. An ETF is transacted
through a broker and held in
dematerialized form. Avail-
ability of real-time quotes is
another feature present in an
ETF but absent in an Index
Fund where the previous days
NAV is applied for buying or
redeeming. This feature makes
the trading of the ETFs pos-
sible.
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 mar-
ket 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
The author is a member
of the Institute. He can
be reached at palan_ar-
pit@yahoo.co.in
Arpit Palan
700 The Chartered Accountant November 2005
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 au-
thorized participant (market
maker) or institutional inves-
tors 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 de-
cision 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 is-
suer, 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.
ETF Features
Tradability: ETFs provide
investors a convenient way to
gain market exposure viz. an
index that trades like a stock.
In comparison to a stock, an
investment in an ETF index
product provides a diversified
exposure to the market. De-
pending on the index, inves-
tors may obtain exposure to
countries / markets or sectors.
Transparency: ETFs typically
track an index and this pas-
sive index management elimi-
nates any bias resulting from
a manager’s style. The aim is
to achieve greater control and
therefore better long term re-
sults. As an ETF tracks an
index at its NAV, there are no
surprises of under or over per-
formance. The tracking error is
usually very small, although the
measured tracking error can be
greater for ETFs whose under-
lying stocks have different clos-
ing hours however, at creation
or redemption this measured
tracking error would disappear.
In addition, the investor will
know the identity and weigh-
ing of each of the stocks in the
creation/redemption unit.
Cash Equitisation: Investors
with idle cash in their port-
folios may want to invest in
a product tied to a market
benchmark like an index as a
temporary investment before
deciding which stocks to buy
or waiting for the right price.
Cash Flow Management: In-
vestment managers who see
regular inflows and outflows
may use ETFs because of their
liquidity and their ability to
represent the market.
Diversifying Exposure:
If
an investor is not sure about
which particular stock to buy
but likes the overall sector,
investing in shares tied to an
index or basket of stocks pro-
vides diversified exposure and
reduces stock specific risk.
Filling Gaps: ETFs tied to a
sector or industry may be used
to gain exposure to new and
important sectors. Such strat-
egies may also be used to re-
duce overweight or increase an
underweight sector.
Dividends: Except for ETFs
based on a total return index,
which
reinvests dividends,
dividends are paid out to the
investor.
Small denomination: ETFs are
generally priced as a percent-
age of the value of their un-
derlying index. The denomi-
nation is such that the investor
can easily follow the tracking
accuracy to the index. For in-
stance, if the Nifty is at 2023,
the related ETF should ideally
trade at around 202.30 with a
bid/offer on either side of this
value. However, the trading
value of ETF is also affected
by the expectations of the buy-
er or seller.
Risks
All
investments
involve
risk. Like other investments,
index ETFs carry a certain
level of risk for investors as
follows:
Market Pricing: Given that
the market share price is de-
termined by the forces of
supply and demand, not the
underlying net asset value, in-
vestors may purchase shares at
The Chartered Accountant 701
November 2005
a premium or discount to their
net asset value.
Tracking Error: In some cas-
es ETFs pay out dividends
received from the underly-
ing stocks on a quarterly ba-
sis. However, the underlying
stocks pay dividends through-
out the quarter. Therefore,
these funds may hold cash for
various time periods through-
out the quarter, even though
the underlying benchmark in-
dex is not composed of cash.
In addition, due to transac-
tions via market prices rather
than at net asset value, the
performance based on an in-
dex ETF may not completely
replicate the performance of
the underlying index.
Market Risk: Market prices
for securities and index ETFs
fluctuate daily based on a va-
riety of factors such as eco-
nomic conditions and global
events, investor sentiment and
security-specific factors. The
degree of volatility in general
in the markets has increased
over the last several years. The
prospect of a market decline
and its impact on security and
fund prices should be consid-
ered as general market risk.
Credit Risk: Credit risk refers to
an issuer’s ability to make pay-
ments of principal and interest
when due. An interruption in
the timely payment of principal
and interest (such as on a cor-
porate bond) may adversely af-
fect a fund’s net asset value and
ability to pay dividends.
Interest Rate Risk: Prices of
bonds tend to fall as interest
rates rise, and as interest rates
fall (bonds with longer ma-
turities tend to fluctuate more
in price in response to such
changes). For index ETFs that
hold bonds in their portfolios,
this risk can be significant, al-
though most funds hedge this
risk through various market
instruments.
Advantages and
Disadvantages
Tradable and Diversifiable:
ETFs have in them the twin
feature of being tradable and
diversifiable. One can trade a
stock but then it is not diversi-
fiable. 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 con-
flicts are reconciled by an ETF
that is at once tradable and is
a diversified portfolio too. It is
these two features, working in
tandem that makes it a finan-
cial product of choice.
Low cost: Due to reduced
marketing, distribution and
accounting expenses and the
passive nature of index in-
vesting, the expense ratios are
typically lower than those for
702 The Chartered Accountant November 2005
many traditional mutual funds.
As the ETFs are listed on the
exchange, the cost of distri-
bution is low. Furthermore,
exchange traded mechanism
reduces minimal collection,
disbursement and other pro-
cessing charges.
Arbitrage with futures: ETFs
being a versatile product can
be used to exploit the pricing
differences arising between
Index futures and itself using
the arbitrage strategies.
Transparency: Just like the
index fund, the portfolio of
an index fund has no mystery
to it. Everybody in the par-
ticipating market is aware of
the stocks that it is tracking
and therefore need not worry
about a change in the stocks
being traded in.
Continuous Pricing:
Un-
like traditional mutual funds,
which are only priced at the
end of each day, index ETFs
are priced and can be pur-
chased and sold throughout
the trading day.
Portfolio Transitions: Many
investors may move assets be-
tween funds and investment
styles, but may wish to stay
fully invested in the market.
Rather than allowing assets
to sit idle in cash, index ETFs
provide a mechanism to stay
fully invested in a particular
market segment while evalu-
ating options for further in-
vestment.
Absence of Prior Active Mar-
ket: 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 liquid-
ity possible.
Large Investments: In order
to deal directly with the fund
houses large capital invest-
ments are required. For exam-
ple 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 in-
stitutional buyers and sellers
become the big fish.
Broker Charges: Broker charg-
es 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.
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.
ETFs and Mutual Funds
– A Comparison
In essence, ETFs trade like
stocks and therefore offer a de-
gree of flexibility unavailable
with traditional mutual funds.
Specifically, investors can trade
ETFs throughout the trading
day as in stocks. In compari-
son, in a traditional mutual
fund, investors can purchase
units only at the fund’s NAV,
which is published at the end
of each trading day. In fact, in-
vestors cannot purchase ETFs
at the closing NAV. This dif-
ference gives rise to an impor-
tant advantage of ETFs over
traditional funds. ETFs are
immediately tradable and con-
sequently, the risk of price dif-
ferential between the time of
investment and time of trade
is substantially less in the case
of ETFs.
ETFs are cheaper than
traditional mutual funds and
index funds in terms of fees.
However, while investing in
an ETF, an investor pays a
commission to the broker. The
tracking error of ETFs is gen-
erally lower than traditional
index funds due to the “in-
kind” creation / redemption
facility and the low expense
ratio. This “in-kind” creation
/ redemption facility ensures
that long-term investors do
not suffer at the cost of short-
term investor activity.
ETFs can be bought/sold
through
trading
terminals
anywhere across the country.
Unlike Mutual Funds, ETFs
can be used for hedging and
arbitration other than that for
equitising cash.
Investors are not exposed
to the trading styles, personal
agenda and sheer good luck of
the fund manager.
For a long-term investor,
there is no cost for the port-
folio turnover so common to
all conventional mutual funds,
nor does the investor share
the costs in buying and selling
holdings to accommodate new
investors or those who are liq-
uidating.
ETFs and Futures
Even though ETFs and Fu-
tures allow investors exposure
to an index, they are different
in many regards. While Fu-
tures is a derivative product and
trades in the F&O segment of
NSE, ETFs are a cash market
product and trade in the Capi-
tal Market segment of NSE.
The maximum tenure available
for futures is 3 months while
ETFs can be held for as long as
the investor wants.
As per William Sharpe,
well known Economist, all ac-
tive fund managers together
can never outperform the mar-
ket. Consequently, all classes of
investors viz. institutional and
retail are increasingly moving
towards investing in well-de-
fined indices, which are pro-
fessionally managed. r