The Hindu Business Line : Exchange traded funds: Are they for you?

EXCHANGE traded funds (ETFs), which have grown rapidly to manage $110 billion in assets in the US, have just made a small beginning in the Indian markets, with two ETF products. How are ETFs different from open-end index funds and who are they suitable for?

What they mean?

ETFs are index funds listed on the stock exchanges and traded in much the same way as stocks. An ETF invests in a basket of stocks which blindly mimics a chosen market index (say, the S&P, CNX, Nifty, or the BSE Sensex). For convenience, the Net Asset Value (NAV) of the ETF is usually represented as a fraction of its underlying index. For instance, the Benchmark Nifty ETF has an NAV that is one-tenth of the prevailing Nifty value.

How they are different from open-end index funds?

In an open-end index fund, an investor purchases units from the fund itself and to redeem them sells the units back to the fund. Therefore, each entry or exit from the fund expands or shrinks its corpus.

Transacted through brokers

The ETF units are listed on the stock exchange and traded like stocks. An investor wanting to invest in an ETF may place an order with a broker just as he would do for any stock, with a similar procedure for selling them. This ensures that the entry or exit of investors on a day-to-day basis does not impact the size of the fund. The ETF units are held and transacted in demat form.

Real-time quotes

Unlike an open-end index fund, where transactions are processed at the previous or current day's NAV, investors can trade the ETFs on a real-time basis. The ETFs are quoted and traded on the stock exchanges like other stocks.

How an ETF operates

An ETF usually builds its corpus by inviting bulk subscriptions from large institutional investors who swap a basket of index stocks in kind, for a unit (termed a "creation unit") of the fund. The purchase of a creation unit usually requires the investor to offer a portfolio of stocks which approximates the underlying index, with a small cash component to compensate the fund for transaction and processing costs.

Pros and cons

Why would a small investor choose an ETF over a plain vanilla index fund? Proponents of ETFs advance three key advantages:

Low cost: In theory, an ETF is expected to have a lower cost structure than an open-end index fund for two reasons. One, since the fund's corpus does not change on a day-to-day basis, it requires less churning, saving the fund brokerage, commission, and transaction costs. Second, since new units in the fund are issued only in exchange for the underlying basket of shares, the fund does not have to churn its portfolio when it receives fresh inflows.

The fund also does not have to maintain a significant cash component to service redemption demands.

Low tracking error: Low levels of churning in the portfolio and a lower cash component also make for a lower tracking error (the margin by which an index fund trails its underlying benchmark) in an ETF than an open-end index fund. However, even the ETFs eliminate only a few sources of tracking error. An ETF would have to incur certain costs on management and administration. It may hold cash to meet the consequences of corporate actions (say, adjustments for mergers, hive-offs, or dividend payouts). An ETF may also accumulate tracking error due to halt of trading in a stock (say, due to circuit-filters).

Intra-day trading: While index funds only allow you to transact at historical NAVs, an ETF allows an investor to transact on the index on a real-time basis. Therefore, investors who really like to put a fine point on their timing and those who would like to take advantage of the arbitrage opportunities on the index may find the ETFs scoring over the traditional open-end index fund.

In practise...

Though factors such as low costs, low tracking error and intra-day trading appear to tilt the argument in favour of ETFs, investors need to bear the following factors in mind while deciding between the two products:

The real expense ratios: Though theory suggests that an ETF is a more cost-effective product than an open-end index fund, investors may do well to actually compare the expense ratios set out in the offer document of an ETF with that of an open-end index fund. At present, both the Nifty Benchmark ETF and the PruICICI SPIcE Fund have projected much lower expense ratios than is normal for an index fund. While the majority of open-end index funds have expense ratios between 1.5 and 2 per cent, the Nifty BeeS projects annual recurring expenses at 0.8 per cent and the SPIcE Funds at 1 per cent. But with competition constantly whittling down the costs of open-end funds, the difference may narrow.

Brokerage costs for investors: While the ETF may incur lower brokerage costs due to lower portfolio churn, an investor has to shell out brokerage costs each time he enters or exits from an ETF. Investors who plan to phase out their investments in an ETF over time, or invest in periodic instalments would have to incur these costs for each transaction.

Liquidity risks: While liquidity in an open-end fund is assured at NAV-linked prices, liquidity in the ETFs are linked to the demand for the units and transaction volumes for the ETF units on the exchange. If trading is thin, there is a possibility that an investor may not be able to liquidate his ETF at the chosen time. Both the Nifty BeeS and the SPIcE offer an exit option to investors (through the fund) if there are no quotes on the ETF units for five consecutive days. However, the exit load imposed in this case is quite stiff at 2.5 per cent of the NAV for the SPIcE Fund and at 5 per cent for the Nifty BeeS Fund.

Do you really need intra-day trading?: Finally, the facility of intra-day trading may not mean much to long-term investors or to small investors in index funds. Few small investors would really be able or willing to track the indices minutely enough to time their investments to the lowest point reached during the day's trading. Given the large risks involved in trying to time the markets, efforts at "day-trading" on the index may actually prove counterproductive. Not to mention the large capital gains tax and transaction costs, which would shave a significant chunk off the effective returns.

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