In the Runup to Budget 2009 series, we got numerous requests about knowledge intensive articles. In response to those, we present this article on Exchange Traded Funds by our guest authoress – Payal Wadhwa. This is her second article on strat.in (link: first article ) Other articles in the Budget series on strat.in are: Is Right always Right , Why should fringe benefit tax be diluted and Stock Market & Mango Man . We thank Payal for her contribution and look forward to more insightful articles from her in future as well.

In a path breaking decision, Securities Exchange Board of India (SEBI) has decided to do away with entry loads on mutual funds in India w.e.f. August 1, 2009. Entry load is a load charged by the mutual funds to meet distribution and marketing costs. It ranges from zero (for debt/income funds) to 2.25% (for equity funds).The entry load was deducted by the Mutual Fund/AMC upfront from the investment amount of an investor and then passed on to the Mutual Fund Advisor/distributor.

An investor who comes directly to the Fund was exempted from Entry Load. However as per the new norms SEBI has altogether decided to do away with Entry Load on all Mutual Fund Schemes.So any upfront commission to distributors will be now paid by the investor directly to the distributor.
These initiatives not only bring about transparency but will also go a long way in empowering retail investors as they will have the freedom to directly negotiate on the fee that they pay based on services rendered by distributors while purchasing mutual funds. (Unlike earlier where investors paid a fixed entry load to the fund)

At this juncture let’s talk about Indian mutual fund schemes that have always existed without any entry loads and are available to the Indian Investor. These categories of funds are passive index funds-both open ended and exchange traded.

Let’s Talk about Exchange Traded Funds.

ETFs are Exchange Traded Funds that are essentially index funds listed and traded on exchanges like stocks. They can be bought and sold like stocks and are credited to Demat accounts-again exactly like stocks. Until the development of ETFs, it was not possible to buy and sell Mutual funds on the exchange at real time Fair Value.

Investors don’t have to go directly to the Fund or through a distributor to buy an ETF as it is bought and sold on the exchange. ETF units are traded on the bourse between investors. An investor needs to have a demat account and a broking account. The Investor pays brokerage (which is negotiable and varies from broker to broker) and Securities Transaction Tax on purchase or sale of units as in case of any stock.

Think of it as a mutual fund that you can buy and sell in real time at a price that changes throughout the day based on the price movement of its underlying portfolio or basket of securities.

E.g. an ETF that tracks the Nifty Index will have its portfolio composition exactly similar to the underlying index i.e. Nifty. 1 Nifty ETF unit or share will represent 50 stocks of the Nifty in the exact weighting and composition as they exist in the index.

In other words it is akin to buying a Nifty share in the ‘cash market’-it is important to understand this distinction as different from the futures segment.

NAV of one unit of ETF is normally kept in proportion of Index level. For example Indicative NAV of Nifty BeES(an ETF available on Nifty Index) is around 1/10th of the Nifty Index. E.g. if the Nifty Index is at 4500-an ETF investor should be able to buy a Nifty ETF share from the secondary market around 1/10th that level or a price of around Rupees 450. The minor variation in actual quotes could be due to the bid-ask spreads and accumulated dividends-exactly like stocks.

A Retail investor achieves the following by investing in an index ETF:

a) Diversification-because the underlying index is a diversified portfolio. This eliminates the often uncompensated risk of concentrated investments in individual stocks.

b) Elimination of fund or portfolio manager risk-because an investor remains passive by investing in the index. Selecting an outstanding manager in advance from the many identical choices available is a task as complex as selecting good stocks. Consistency of good selection (i.e. stocks, sectors and managers) remains an eternal challenge for both investors and financial advisors.

c) The logical return from any financial or stock market is the ‘average’ of all investors in the aggregate. The portfolio which ideally represents this ‘average’ is the cap weighted index fund or ETF. At any given point in time a few active investors will out perform the average-hence by default their counterparts i.e. other investors will have to suffer a loss by an equivalent amount. The index investment eliminates this randomness and transience of ever changing individual out performers-stocks, sectors and portfolio managers.

d)The cardinal principle of ‘asset allocation’ or diversification between various asset categories can be best practiced using ETFs. For example an investor can allocate his monies between large caps, mid caps, gold and fixed income by investing in ETFs that mimic the Nifty, Nifty Junior indices-as well as ETFs that represent gold and money market instruments as the underlying securities.

e) Stock markets can be volatile at times-hence unlike an open ended MF scheme with end of the day NAV-an ETF investor can buy or sell units at ‘real time’ NAVs from the secondary markets through a broker. The logistics of filling in purchase and redemption slips for an open-ended fund are thus eliminated.

f)The lower cost related to ETFs are an added advantage. ETFs charge only 0.5 % -1% as management fees. The difference in costs is obvious. An actively managed mutual fund deducts expenses of up to 2.5 per cent%. More importantly, fund expenses are kept to the bare minimum as ETFs do not buy or sell the underlying scrips very frequently unlike in actively managed funds as they passively track Index Funds.

Also Stocks in an index are generally liquid as ‘impact cost’ is one of the criteria for selecting the stock in an index. A fund manager on the other hand could end up investing in highly illiquid stocks-which have an ‘impact cost’ in case of redemption pressures.

g) Lastly An ETF ensures Equitable Structure. Open ended MF schemes are a common pool of money-hence long term investors have also to bear costs of other investors in the pool who are short-term. The ETF because of its unique structure eliminates this serious problem-the individual ETF investor who is trading bears his own brokerage costs-as well as the bid-ask spreads. So if you are a long term investor you will not be affected by other investor’s movement in and out of the fund.

A long term Investment is best done through a low cost ETF.As of today there are a variety of ETFs available in the Indian markets to take exposure to the entire market and to specific sectors as well.

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