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.

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.

Here's 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 AMC's the Banking BeES (there are few banking sector funds but not bank-index funds) saw a jump of AUM from about Rs 370 crore (Rs 3.70 billion) in June 2005 to almost Rs 7,400 crore (Rs 74 billion) by December 2006. This makes it the largest MF scheme, much higher than about Rs 5,000 crore's (Rs 50 billion) Reliance Equity Fund.

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 mutual fund, in the sense that:

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

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.

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.

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

Disadvantages of investing in ETFs

• 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.
• You can't 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.

The author is an investment advisor and can be reached at sanjay.matai@moneycontrol.com.

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