The ETF advantage

For most investors, mutual funds (MFs) are the preferred route for investment in equities. They find it prudent to leave the hassles of investing in stocks to fund managers, who have the requisite expertise and infrastructure at their disposal, rather than get into equities on their own, which can take a huge toll of their time and, in case of any misjudgment, their investments. But the almost runaway rise in the stock market indices since April last year (62 per cent in Sensex and 56.6 per cent in Nifty), which investors and experts alike see continuing unabated over the long term, has brought the focus back on a less celebrated but very useful investment product that combines the best of both worlds—the relative safety of MFs and the freedom and flexibility of investing directly in stocks: ETFs or exchange traded funds.

Rs 1,00,000# INVESTED A YEAR AGO IN THE FOLLOWING HAS TODAY BECOME... Diversified Equity Funds^: Rs 1,90,400* ETFs^: Rs 1,89,360* Index Funds^: Rs 1,71,170* Reliance Industries: Rs 1,58,450* #As on February 5, 2009 *As on February 4, 2010 ^The returns are average of top performing diversified equity, index and exchange traded funds —Source: BT Research

So, what exactly are ETFs? They are hybrid products with features of both a mutual fund and exchange listed securities. An ETF represents a basket of stocks that forms an index such as Nifty 50 or Sensex 30. ETFs are traded on the stock exchange and can be bought and sold directly during trading hours just like individual stocks. Their unit prices are derived as a proportion, usually 1/10 or sometimes 1/100, of the index they track.

Consider this: Rs 1,00,000 invested a year ago in a top ETF has given returns of close to 90 per cent, which is second to only the average yield of the top performing diversified equity funds and better than the average return of the best performing index funds and an outperforming stock like Reliance Industries (see graph on the opposite page). Says Gaurav Mashruwala, Director, ACE Financial Advisory Services: "In the last one year, ETFs have performed well due to the sharp run-up in the stock market. If you're trying to get market returns, then ETFs still appear to be an attractive option for investors with a long-term horizon."

One of the big selling points for ETFs is that they minimise risk and help investors diversify their portfolio. Investing through ETFs ensures that the downside risk is defined, i.e. if the market falls by, say 10 per cent, it is likely that the ETF will also fall by the same proportion. Analysts believe that most investors don't have the expertise to take calculated risks while building a stock portfolio. The problem gets worse when they get busy and forget to even look at the portfolio they have built so carefully. "ETFs, on the other hand, are automatically diversified equities. They greatly reduce the risk because there is minimal exposure to any particular stock," says Rajan Mehta, Executive Director, Benchmark Mutual Fund.

Another advantage of ETFs is that they never seek to beat the market. Instead, their goal is to move in tandem with a particular index. To put it differently, many ETFs strive for a beta of 1 relative to the underlying market index. A beta of 1 means that the ETFs are neither more nor less volatile or risky than the wider market.

How exactly do ETFs function?
ETFs have a very transparent portfolio holding and predefined creation basket. Since the price of ETFs is driven by market forces (demand and supply), usually they trade at a premium or discount to their NAVs (net asset values). The role of the asset management companies (AMCs) is to keep the market price of the ETF close to its NAV with the help of market makers. Such market makers (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. The arbitrage mechanism ensures that there is no significant premium or discount to the NAV. At the same time, additional demand/supply is absorbed due to the action of the arbitrageurs.

HOW TO BUY AN ETF AND OWN AN INDEX

What is an ETF?	How to buy ETFs?	What do you get?	Returns	ETFs vs Index Funds
It tracks a stock index. Each ETF unit is set at a fractional value of the index it tracks. For example, the Nifty BeES unit is set at 1/10th the Nifty's value.	ETFs are listed on the stock exchanges. You buy or sell an ETF just like you would buy or sell a listed stock. You pay brokerage on each buy or sell. Prices change real-time as the index value changes.	Each ETF unit is priced at an agreed fraction of the index (usually 1/10th). You can sell an ETF for the real-time cash value during trading hours. You can redeem ETFs in kind for the underlying stocks in proportion.	An ETF will yield almost exactly the same return as the index that it tracks. It is a passive investment with a fixed basket of stocks. It can be traded intra-day or held for the long term as you choose.	ETFs offer better liquidity and need lower minimum investments. ETFs have lower tracking errors. But ETFs require a demat account. ETFs don't offer systematic investment plans

In India, ETFs are often confused with index funds. This is because both track major indices. However, both differ significantly in terms of transaction costs, flexibility and other qualitative issues. Index funds make new fund offers (NFOs) and invest the corpus in the index-basket a fund tracks. Units are traded at NAVs based on closing prices.

Investors deal with the fund house. On the other hand, an ETF is not created through an NFO. The managers interact with "authorised participants" (APs or member-brokers), to create the ETF. An AP offers the ETF manager a complete basket. (If the AP exits, ETF units are redeemed for the shares.) APs sell the ETFs onwards, charging brokerage. Prices change as the index fluctuates.

On most counts, ETFs score better than index funds. Despite the fact that index funds are passively-managed and don't charge management fees like other mutual funds, they still have higher expense ratios (1 to 1.5 per cent) than ETFs. The average expense ratio for an ETF is between 0.5 per cent and 1 per cent.

Besides, index funds carry entry/exit loads that vary from 1.5 per cent to 2.25 per cent. ETF investors have to pay a brokerage commission at the time of buying and selling that is far lower than the load charges. As compared to index funds, which require a minimum investment amount of Rs 5,000, ETFs offer a low-ticket entry for investors with limited funds who want to get into equities. Due to their structure, ETFs have an inherent advantage over index funds insofar as they mimic the exact performance of the underlying index.

In contrast, index funds have to keep some amount in cash to deal with expenses (asset management fees, agents' commissions, brokerage on buying and selling of shares) and potential daily redemptions. This "cash drag" brings in negative tracking errors—which means lower returns of an index fund from the index to which it is benchmarked. "Index funds cannot be used to take advantage of short-term movements in the market. They don't let you buy or sell the index at the exact point in time you wish to. In order to profit from the price movement in your fund, you would have to wait until the end of the business day when the net asset value is calculated.

On the contrary, ETF allows investors to take advantage of intra-day changes in the market," says Lakshmi Iyer, Head (Products), Kotak Mahindra Asset Management, adding that over the next 12-15 months, ETFs would be able to give around 15 per cent returns.

"Investments in ETFs should be made with a time horizon of at least one year. It is advisable for an investor to allocate 10-15 per cent of equity portfolio towards ETFs," he says. Agrees Mashruwala: "In the current market scenario, there exists tremendous long-term investment opportunities in the stock market. Keep your ETF investment for a longer time horizon to reap the actual benefits."

Currently, India has a total of 11 index-based ETFs largely tracking the Sensex, Nifty and Bank indices and their total assets under management (ETF) stand at Rs 654.52 crore (as on January 29, 2010). But despite so many good qualities, why have ETFs failed to become as popular as mutual funds? First, there is a lack of information and marketing of these products on the part of the asset management companies.

Further, brokers prefer their clients to trade stocks as each transaction earns them commission, whereas ETFs are bought for a longer period of time and traded less frequently. Also, there isn't much variety in ETFs today: Only two companies (Kotak AMC and Benchmark) have more than one ETF product in the market. Globally, there are ETFs to cover every major index, asset class, and niche within them.

There is another reason why ETFs have not become very popular yet. Says Mashruwala: "For a vast majority of investors, systematic investment plan (SIP) offered by mutual funds look very attractive as a small scale saving option. SIP in ETFS is a manual effort while SIP in mutual fund is an automated process." But things are expected to change in the near future. Experts believe that as the volumes start picking up and investors' interest rise, more funds tracking a wider range of indices will make their way to the markets. That probably will be followed by hardsell as well.