Business Today

On the right track

You should accumulate exchange-traded funds in the coming months. And the best ones are those that have low tracking errors.

Nitya Varadarajan | Print Edition: November 2, 2008

The next year could turn out to be an exciting one for bottom-fishers and investors in gold. With stock prices tumbling, valuations have turned attractive, while gold is once again proving to be a hedge against the global financial crisis. For investors, the best way to participate in both these asset classes is through exchange-traded funds (ETFs). As these funds trade like stocks on the exchange, you can buy and sell them any time as you like, making them perfect vehicles for turbulent times like these.

Over the last few years, ETFs have caught on with big and small investors alike. They can track any market segment, index or commodities. Whether investors are looking for large-cap growth stocks, mid-cap stocks, banking stocks, or commodities like gold, an ETF will serve the purpose. In the offing are ETFs based on silver and oil as well. Globally, there are ETFs on tech, metal and overseas stocks also.

Buy the basket
Perhaps, the biggest advantage investors have is that they can buy an entire basket of stocks with just one trade—and for as little as a few thousand rupees. At times such as these, it means an investor can accumulate a basket of stocks every time there’s a dip in the stock market. So far in India, there are three categories of ETFs—the broad market indices, financial stocks and gold. The global financial turmoil has taken its toll on the first two segments and boosted the fortunes of the yellow metal.

For the small investor, these are the best times to invest in all three market segments. But before you buy an ETF, consider a few factors. First, check its tracking error. The most efficient funds are the ones with the least tracking error. The net asset value (NAV) of the ETF should be as close to the face value of the units, barring fund management expenses. A tracking error is the difference between the NAV of the benchmarked index (which the ETF mirrors) and the face value of the ETF. Says Rajan Mehta, Executive Director, Benchmark AMC: “Buying and selling happens any time during the day, but the final value has to be reconciled with the index’s closing price.”

The ETFs way

• Accumulating ETFs can prove to be cost-effective and profitable in the long haul.

• Gold ETFs are an excellent hedge in these uncertain times. Their lower volatility reduces overall portfolio risk

• On days when the market goes into a tailspin, long-term investors can buy into index-based ETFs. This strategy will fetch you more units at a lower cost

• ETFs are traded like shares on the stock exchange, but they track the underlying indices or commodities. They are more cost-efficient than index funds or commodities

• ETFs can be illiquid at times, which increases the spread between the commodity or index and the unit price of the ETF. Check the underlying asset price before closing your purchase

So, keep track
All ETFs have tracking errors, depending on market conditions and expenses or when there’s a stock split. “Tracking errors result because of fund management charges or when the companies in the basket declare dividends, bonuses, rights, etc., which take a little time to reconcile,” says Lakshmi V. Iyer, Head (Fixed Income and Products), Kotak Mahindra AMC. Fund houses that can reconcile these in quick time usually have low tracking errors. SEBI has fixed a formula to calculate tracking errors by comparing the closing price of the ETFs underlying index, say, the Sensex to its NAV.

Usually, index funds have higher tracking errors than ETFs. That’s because index funds have to wait for a longer time to collect cash from individuals and create a large enough corpus to buy the entire basket of shares. But ETFs create or redeem units with the help of authorised participants (APs), essentially large brokers or institutions, who create or redeem the units in bulk, thus, bringing down the tracking error. On the other hand, authorised participants also help keep the prices of ETFs as close to the underlying asset class as possible. At times, the market price of ETFs could trade at a premium or discount to the actual price of the underlying asset, such as, an index or a commodity. If there’s a big discrepancy, an authorised participant quickly conducts an arbitrage trade to keep the price of the ETF in check.

As of now, the difference between the market price and the NAV of the ETF is not very wide in index-based ETFs, but it does vary a bit in the case of gold ETFs. This difference can some times tot up to as much as Rs 40-50 per gram. Since there’s a lag in moving physical gold, the spreads are created. Says Mehta: “Gold is an asset that needs to be moved physically in case of a sudden spurt in demand. This leads to a time lag and a price difference from that which gets declared at close of day.” Iyer further explains that the Kotak Gold ETF, for instance, is benchmarked against a London index and not the local MCX. “When gold prices came down to $735 or Rs 35,280 an ounce, you notice that we (ETFs) were at a premium. This is because gold producers would not accept that price and there was a shortfall,” she says.

However, in India, tracking errors are not too high. According to Anil Rego, CEO & Founder of Right Horizons, tracking errors in most ETFs amount to just under 1 per cent, though it increases occasionally. “Despite the volatility we have been witnessing in the last three months, ETFs show lesser tracking error than typical index funds—though they can still improve,” he says.

Check your preference
Another thing investors should note in an ETF is its underlying benchmark. If you want exposure to the broader market such as the Nifty, invest in an ETF that tracks the Nifty. For now, the three broad segments of ETFs in India all hold promise for plenty of reasons, and investors can accumulate any or all of them.

The broad market has been beaten black and blue, so investors particularly interested in large-cap stocks can buy Nifty or Sensex ETFs over the coming months. The financial sector has also been hit hard by the financial crisis. Stocks in this segment, too, have been badly mauled. The CNX Bank Index is down 47.2 per cent since the beginning of the year compared to the Sensex’s dip of 44.2 per cent. On the other hand, gold has proved to be a hedge in this financial crisis. While there are signs that it may dip a little in the coming weeks, over the next six months to a year, a gold ETF should add glitter to your portfolio.

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