Exchange traded funds, demystified!

Exchange Traded Funds (ETFs), as their name implies, are mutual funds that are listed and traded on the stock exchange.

These funds can be bought and sold on the stock markets on a real time basis. In the developed economies, ETFs have an established track record, however in India, they are still evolving.

ETFs can be open-ended or close-ended i.e. an open-ended ETF can issue fresh units on a continuous basis. Being open or close-ended does not define the nature of ETF; their nature is defined by the fact that they are traded on the stock exchange.

Also, ETFs can be categorised as actively managed and passively managed in terms of fund management style. When ETFs are actively managed, the aim of the fund is to outperform the benchmark index. To that end, the fund manager has a free hand in terms of making investments.

Conversely, in passively managed ETFs, the stock picks are aligned to that of the benchmark index in exactly the same proportion/weightage.

With stock markets hitting a purple patch, ETFs have caught investors' attention in recent times. In this article, we highlight some of the positives and negatives of ETFs, which will help investors, make an informed decision while investing in them.

• Since ETFs are traded on the stock markets, they offer investors a convenient investment vehicle. The units of an ETF can be bought and sold through any SEBI (Securities and Exchange Board of India) registered broker on a stock exchange like stocks. All investors need to have is a demat and a broking/trading account with the broker.
• In contrast to the regular mutual fund scheme wherein investors have to buy or redeem units at the closing daily net asset value (NAV), in an ETF the same can be done on a real time basis. ETFs offer the convenience of intra-day sale and purchase of units on the exchange. This means that investors can enter or exit ETFs anytime during trading hours, which is not possible with regular mutual funds.
• Loads and expenses charged are a major differentiating area between ETFs and regular mutual funds. While regular funds charges entry/exit loads, ETFs do not impose the same. Since ETFs are transacted over the stock exchange, investors have to pay brokerage and Securities Transaction Tax (STT), in case of an equity ETF, to the stock broker on each leg of the transaction (i.e. at the time of buying and selling). In terms of expenses, ETFs usually tend to have a lower expense ratio (normally less than 1%) than regular mutual funds (can be as high as 2.50%).
• In a regular equity fund where units are bought and sold at the AMC's (Asset Management Companies) end, it's the long-term investor who could potentially suffer if the fund manager is forced to sell his best stocks to meet liquidity requirements (say to meet an unusually high redemption pressure). Such a scenario can't occur with ETFs, since all the buying/selling is done on the exchange. Hence the interest of long-term investor is not compromised.

ETFs have their fair share of negatives as well:

• Close-ended ETFs often trade at a discount to the NAV. This has a lot to do with the close-ended nature. Since close-ended ETFs do not issue fresh units, the mis-pricing between the ETF price and the NAV takes the shape of a discount.
• Also, investing in ETF requires investors to have a demat as well as broking/trading account with a SEBI registered stockbroker. The same is not required while investing in regular mutual funds. For a retail investor, who doesn't have much knowledge about trading, this could be a restricting factor while investing in ETFs.

Having discussed what ETFs have to offer to investors, we now discuss how they rank on the NAV appreciation front. For this purpose, we have chosen three open-ended ETFs, (which are passively managed i.e. they track designated benchmark indices) and put their performance across various time frames under the scanner.

ETFs: How they fare

Over 3-Yr, when the S&P CNX Nifty has risen by 30.58% CAGR - Compounded Annualised Growth Rate, UTI SUNDER has clocked a growth of 31.21% CAGR, while Nifty BeES has risen by 30.56% CAGR. Similarly the BSE Sensex (34.82% CAGR) and PruICICI SPIcE (35.56% CAGR) have pitched in comparable performances as well. Broadly speaking, the ETFs have been successful in tracking their benchmark indices.

Also, as mentioned earlier, ETFs have lower expense ratios vis-à-vis conventional mutual funds. For example, in the ETFs above, UTI SUNDER (0.50%) had the lowest expense ratio while PruICICI SPIcE (0.80%) had the highest.

In a major development, a new and rather unique product made its debut in the ETF segment. Recently, fund houses received a go ahead from SEBI to launch Gold Exchange Traded Funds (Gold ETFs). Gold ETFs offer investors an easy means of investing in the bullion market and trading in gold without actually taking the physical delivery and without compromising on the quality.

The working of Gold ETFs will be akin to that of regular ETFs i.e. investors can buy and sell the units of Gold ETFs directly on the stock exchange through a SEBI registered broker.

Benchmark Mutual Fund is the first fund house to launch Gold ETF named (NFO-New Fund Offer period is from February 15, 2007 to February 23, 2007), which will be listed on the NSE (National Stock Exchange); similar offerings from other fund houses are on the anvil as well.

The product is designed to provide returns (before expenses) that closely correspond to the returns provided by domestic price of gold through physical gold. The minimum number of units of Gold Bees that can be bought or sold is 1 unit; and this 1 unit will be approximately equal to the price of 1 gram of gold.