Understanding ETFs

Learn how you can use Exchange Traded Funds (ETFs) to guarantee that your portfolio grows at exactly the same pace as the indices you track.

By Tejas Bhope | Print Edition: December 14, 2006

Sensex, Nifty, Bank Nifty—a newcomer may think that the stock market consists of these exotic creatures. Mutual fund houses trumpet it from the rooftops when their schemes beat these benchmarks.

It doesn’t happen that often. In the past one year, only 23 of the 144 equity schemes beat the Sensex. Or six out of seven managers did not beat the m a r k e t index. An index is a synthetic instrument— it averages returns of many stocks. An active investor gets returns that vary from the indices.

Different but not necessarily better returns: it’s very difficult to outperform the indices in liquid markets with many players. The “efficient market hypothesis” suggests that, in an efficient market, prices quickly reflect information and nobody can systematically pick winners.

You may wonder, “What’s the point of chasing excess returns?” After all, indices produce excellent returns. The Nifty for instance, has risen 29% per year since 16 November 2001. If you think this way, opt for what Sanjiv Shah, executive director of Benchmark Mutual Funds (see Guest Column) calls the “cheap, simple, boring route”.

There are two ways to get returns close to market averages: One is to invest in index funds. Another is to invest in ETFs. Both instruments mimic returns of indices such as the Nifty or Sensex. The key differences lie in the structure and the costs.

Index funds make new fund offers (NFOs) and invest the corpus in the index-basket it tracks. Units are traded at NAVs based on closing prices. Investors deals with the fund house (see Index Funds).

ETFs trade like individual stocks on the stock exchange. An ETF is not created through an NFO (see ETF Dynamics).

The managers interact with “authorised participants” (APs or member- brokers), to create the ETF. An AP offers the ETF manager a complete basket o f index stocks in proportion. In return, the fund issues 10 ETF units where each unit is priced at 1/10th of the indexvalue. (If the AP exits, ETF units are redeemed for the shares.) APs sell the ETFs onwards, charging brokerage. Prices change as the index fluctuates.

You log on to an online platform (type “Nifty”) or call your broker with an order for say, 100 units of Benchmark’s Nifty BeE ETF. If the Nifty is at 3800, each unit costs Rs 380 plus brokerage. Your brokerage cost is somewhere between 0.25% and 0.75%. The ETFs are transferred to your demat account and the cash to the seller. When you sell, the units are transferred out of your demat and you receive cash.

What’s the difference for an investor? ETFs are cheaper if the brokerage is lower than fund-loads. ETFs are also more liquid.

Suresh Sadagopan, chief financial planner of Ladder 7 Financial Advisories points out another advantage: “You can accumulate one ETF unit a day by investing invery small amounts. On the other hand, index funds require minimum investments of Rs 5,000.”

There is almost no “tracking error” in an ETF. Index funds have larger “tracking errors” as the difference between the index returns and the fund return is known (see table Error in Tracking).

Tracking error occurs due to changes in indices, bonuses or dividends. The fund manager must rebalance each time and this churn causes differential returns.

Nilesh Shah, chief investment officer, Prudential ICICI Mutual Fund explains: “In addition to rebalancing of portfolio, tracking error is caused by the churning incurred to manage cash inflowsand outflows.” This track error can cause large variances in returns.

ETF units are created and redeemed in kind. The number of outstanding units increases if investors deposit shares; or it reduces if ETF holders redeem units for underlying shares. ‘Inkind’ creation and redemption ensures that ETFs trade close to their fair value at any given time.

The expense ratios of index funds are typically higher. The average expense ratio of index funds is 1.3% compared to 0.6% foran ETF. Also, some index funds charge an exit load of 0.5-1%.

Brokerage could add up to more if you trade a lot. You must have a demat account and also, systematic plans are unavailable in ETFs.

Fund houses like Benchmark, Prudential ICICI and UTI offer ETFs. More schemes are in the pipeline from Benchmark, which exclusively manages ETFs.

Informs Sanjiv Shah: “Apart from a Gold ETF, we will launch nine ETFs benchmarked against sector indices like telecom, cement, pharma and auto. We will also launch an ‘inverse index fund’ to allow short positions to hedge index exposure.” Savvy traders may combine these plans with derivatives for complex trading strategies.

The choice between index fund and ETF boils down to personal needs. As Nilesh Shah says: “If you want to invest on a real time or intra-day basis, then use ETFs. But from a long-term investment point of view, there is no real difference.”

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