Business Today

Learn the Fund-amentals

Sowmya Kamath | Print Edition: Oct 14, 2012

Exchange-traded funds (ETFs), which offer both the flexibility of a stock and the protection of a fund, are becoming popular with Indian investors.

Unlike mutual funds, which have a single net asset value (NAV) per day, determined after trading for the day closes, ETFs trade on exchanges and their value can fluctuate all the time during trading hours. ETFs, however, invest only in stocks comprising an index. For example, a Nifty ETF will invest in the 50 stocks comprising the Nifty.

Financial planners are increasingly recommending ETFs to investors who have long-term goals and want to invest in equity without taking too much risk. This is reflected in average assets under management in the retail ETF category, which have risen from Rs 59 crore in March 2009 to Rs 394 crore in March 2012, according to the Association of Mutual Funds in India.

However, equity ETF volumes, unlike those of gold ETFs, are still very small compared to the mutual fund industry's total assets. "ETFs became popular with gold ETFs, even though gold ETFs came later than equity ETFs," says Lakshmi Iyer, Head, Products and Fixed Income, Kotak Mutual Fund.

The proportion in which an ETF allocates money in different stocks is often the same as individual stocks' weight in the index. But again, this may not always be the case.

An investor can buy or sell ETFs on the exchange without approaching the fund house. Such trades attract a brokerage. Unlike a regular mutual fund, where investors can buy a fraction of the unit, ETFs are available in multiples of one only. Big investors can directly approach the fund house for sale or purchase if the lot size is big and the units are not available in the market. The lot size is determined by the fund house. Usually, it is more than Rs 15 to 20 lakh.

ETFs have a NAV, too - the price of each unit at the end of the day. But as ETFs trade in real time, funds provide an indicative NAV, or iNAV. ETF prices depend on demand and supply on exchanges. "When there is more demand than the units on sale, the market price may be 25-50 basis points more than the iNAV. If there are more sellers than buyers, the price may be 25-50 basis points less," says Rajnish Rastogi, Senior Fund Manager and co-head, equities, Motilal Oswal AMC.

Thus iNAV may be different from the market price. So, there is a possibility of arbitrage. However, institutional or big investors move in fast to plug any price difference, putting small investors at a disadvantage. An investor can buy on an exchange and sell to an asset management company (AMC), or sell on an exchange after buying from an AMC to gain from arbitrage.

Though ETFs are gaining in popularity, they face liquidity issues. Unlike in the case of a regular mutual fund, AMCs do not deal directly with small investors. If there is not much liquidity in a product you want to buy or sell, you can ask the AMC to give you details of the authorised participant or the market maker who gives buy/sell quotes. A market maker is a broker-dealer firm that accepts the risk of holding particular securities to facilitate trading.

In such a case, there are chances that the quote offered may be less than the market price. So, one must negotiate hard. The market maker accumulates units from retail investors and after acquring a sizeable amount sells to a fund house. "Recently, we found that an ETF which our client wanted to buy was not available in the market in the required quantity. He had to pay a three per cent premium to the market price to acquire it," says a financial planner. However, some fund houses take steps to protect investors' interest. "For three of the ETFs we have launched, in case the market price is at a discount of more than three per cent over a period, we open the ETF for direct redemption by retail investors in multiples of one unit.

This protects retail investors," says Rastogi of Motilal Oswal. This means if the market price of an ETF is at a discount to its iNAV by over three per cent, you can directly contact the AMC for redemption rather than go to the market maker.

Comparing ETFs to mutual funds is like comparing stocks to mutual funds. Every investment is different. One of the main advantages of investing in an index ETF is that you can sell and buy at real time prices rather than wait for the closing of the day to determine the price. Also, one can get access to the equity market but with limited risk. Moreover, the risk of the fund manager's discretion is eliminated.

Courtesy: Money Today 

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