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Thursday, Jan 09, 2003

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Exchange Traded Funds — Web of Spiders and Vipers beckons

Jayanthi Iyengar

AFTER nearly a decade of the bourses seeing few innovative products other than the derivatives, the Indian investors are about to embark on the complex world of Spiders, Vipers, WEBS, Diamonds and Cubes. Just last week, Prudential ICICI Asset Management Company along with the Mumbai Stock Exchange announced the country's first exchange traded fund on the Sensex called SPIcE, thereby opening up a world of new possibilities to investors whose investments habits have thus far been honed only on investing in pure equity, debt, units and, recently, derivatives.

Exchange Traded funds (ETFs), often called index shares, are a hybrid of index mutual funds and stocks. They are the hottest thing going in the international market. But domestic investors, still not conversant with the downside of investing in the capital market, need to first evaluate if the ETFs are the best investment option going for them, before taking the plunge. Even in the US, financial advisors caution that the ETFs are not for everyone. Besides, while they look more attractive compared to open-ended mutual funds, there are several hidden costs and charges involved in dealing with the ETFs, which need to be factored before investors "spice" up their portfolios.

The ETFs represent ownership in a fund, unit investment trusts and depository receipts. Each ETF is designed as a share. Like index funds, the ETFs track a particular market index by holding the stocks of that index. Thus, the Spiders, nicknamed SPDRs or Standard & Poor's Depository Receipts, track the S&P 500 index. Diamonds track the Dow Jones Industrial Average. Cubes follow the Nasdaq 100. And, WEBS, or World Equity Benchmark Shares, tracks the stocks of individual foreign nations. In addition, the US markets offer dozens of new exchange traded funds to choose from. Like index funds, some ETFs also reinvest dividends.

They are certainly available in the US and their prices quoted in the newspapers. They are also available in some of the major UK and European markets. The London Stock Exchange's tutorial on ETFs sums up the instrument's advantage as: "It (ETFs) brings important advantages, in combining, for the first time the readymade diversification of index tracking with the ease and flexibility of trading shares."

While similar to an index mutual fund, the ETFs differ from mutual funds in significant ways. The main difference lies in the fact that unlike Index mutual funds, which can be traded at the end of the day, the ETFs can be bought and sold throughout the trading day. This means that the ETFs carry the advantages of intra-day trading, which is rare with mutual funds. Also, they can be sold short and bought on margin. They carry no sales load, but are subject to commissions.

They are also considered to be more efficient tax-efficient instruments compared to mutual funds. Both the ETFs and the open-end mutual funds provide low stock turnover. This in itself makes both tax efficient because capital gains are realised less often. However, the ETFs are considered to provide a tax advantage not available with mutual funds. Mutual funds sell securities to cover redemptions, thereby giving rise to capital gains. But ETFs do not buy and sell stocks, except to replace a stock that has been replaced on an index (this is because they buy an index). Readjustments might generate small capital gains for investors, but generally the investor faces a tax liability only when he sells the ETF shares for a gain.

In the US, the ETFs, like many other investment instruments, can be bought and sold to offset other investment tax liabilities. This control of tax liability has long been the attraction of owning individual stocks instead of funds. In India, the tax advantage would become clearer as the market for the ETFs evolves and the government formulates its own tax law measures.

Significantly, if all this makes the ETF sound like a far better option than the mutual funds, investors need to think again. In the US, only large institutions tend to deal directly with ETF companies. Small investors have to buy and sell ETFs like stock, through brokers. This means that unlike in the case of investments with mutual funds, broker commissions have to be paid on ETF transactions. Investors can reduce the burden of commissions, provided they trade ETFs long, but ETF traders believe that the very charm of the new investment product lies in its ability to be traded more often than index mutual funds.

Small investors, used to investing in units, need to remember that unlike mutual funds, the ETFs do not necessarily trade on NAV. Like stocks, they may trade at a premium or at a discount. This means that even if the underlying stocks in the basket are doing well, investors may still book a loss by buying the ETFs being traded at a discount. This apart, the ETFs may also be subject to a bid-ask spread. Simply explained, it means that while one may be able to buy an ETF at Rs 16.50 per share, he may be able to sell only at Rs 16. The 50 paise that he is unable to recover, denotes a hidden cost, which may be unknown to a green horn not fully conversant with the downside of the new instrument.

The ETFs are also not appropriate for investors who "rupee-cost average" their purchases or redemptions. This means that investors who buy the same specified amounts of ETF shares every month — an approach often followed by unit holders based on the belief that markets move up and down in specific cycles — may find investments in the new instrument expensive as they would have to pay brokerages on each transaction. This is not the case when unit holders buy a small sum of units each month.

The San Diego Chapter of the Financial Planning Association cautions that some of the same features that make the ETFs attractive substitutes for index mutual funds, may also make them inappropriate for some investors. For example, because the ETFs are stocks, investors may be inclined to "time" the trades. But this approach may be disadvantageous to mutual fund investors, who may be drawn to the ETFs. By training, this class of investors are less likely to watch market movements minute by minute or make trades as often as stock traders. Hence, they may burn their fingers by trying to emulate market practices more familiar to investors in shares.

While the introduction of new instruments and widen investor choices are the need of the hour, lack of investor education in India magnifies the downside risk of dealing in innovative instruments, particularly the hybrids. It is this lack of awareness that often leads to investors to burn their fingers, often resulting in the instrument being blamed rather than the investor himself. It is here that the regulator's role comes in to ensure that no new instrument is introduced without adequate information, or without being accompanied by a sustained effort to enhance the knowledge quotient of the investors.

(The author is Consulting Editor, Business Content with Jain Television.)

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