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ETF What Is ETF, ETF FAQ's, Exchange Traded Funds, ETF For India, ETF Mutual Fund/ MF, NAV

« backFAQs - Exchange Traded Funds (ETFs)   

Ans1.

ETFs offer several advantages to investors: -

1. Can easily be bought / sold like any other stock on the exchange through terminals across the country.

2. Can be bought / sold anytime during market hours at a price close to the actual NAV of the Scheme.

3. No separate form filling. Just a phone call to your broker or a click on the net.

4. Ability to put limit orders.

5. Minimum investment is one unit.

6. Enjoy flexibility of a stock and diversification of index fund.

7. Expense Ratio is lower.

8. Provides arbitrage between Futures and Cash Market.

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Ans2.

ETFs are very popular abroad with nearly 60% of trading volumes on the American Stock Exchange (AMEX) captured by ETFs. At the end of March 2008, there were over 1280 ETFs with assets of US$ 760.80 billion managed by 79 managers across 42 exchanges around the World. Among the popular ones are: -

1. SPDRs - The S&P 500 Depository Receipts were the first ETFs to be in the market in 1993. SPDRs track the S&P 500. There are select sector SPDR funds available. These are traded on the AMEX.

2. QQQs - Popularly known as Cubes, they are listed on the NASDAQ and track the NASDAQ -100. It is one of the most liquid ETFs.

3. iShares - World Equity Benchmark Shares are listed on the AMEX and offer investors access to 17 foreign markets. iShares track the Morgan Stanley Capital International (MSCI) Indices.

4. TRAHK - Trahks is listed on the Stock of Exchange of Hong Kong and the investment objective is to provide investment results that closely correspond to the performance of the Hang Seng Index.

5. TRAHK - Represents an undivided beneficial ownership in common stock of a group of several companies within a specified industry. HOLDRs are unlike other ETFs, which add and drop shares depending on changes in the underlying Index. In HOLDRs, the underlying securities once pre-defined do not change unless due to mergers, acquisitions or other occurrences that lead to the termination of the common shares of the Company.

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Ans3.

While the Expense Ratio of ETFs is generally low, there are certain costs that are unique to ETFs. Since ETFs, like stocks, are bought as shares through a broker, every time an investor makes a purchase, he/she pays a brokerage commission. In addition, an investor can suffer the usual costs of trading stocks, including differences in the ask-bid spread etc. Of course, traditional Mutual Fund investors are also subjected to the same trading costs indirectly, as the Fund in turn pays for these costs.

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Ans4.

ETFs can either be purchased on the Exchange or directly with the Fund. The Fund creates / redeems units only in predefined lot sizes in exchange for a predefined underlying portfolio basket. Once the underlying portfolio basket is deposited with the Fund together with a cash component, the investor is allotted the units.
This is in-kind creation / redemption of units, unique to ETFs.
Alternatively, investors can follow the "Cash Subscription" route in which they can pay cash directly to the Fund for purchasing the underlying portfolio.

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Ans5.

ETFs have a very transparent portfolio holding and predefined creation basket. This allows arbitrageurs to create and redeem units every day through the in-kind creation / redemption mechanism. Such arbitrageurs are always in the market to take advantage of any significant premium or discount between the ETF market price and its NAV by doing arbitrage between the ETF and its underlying portfolio.
Thus, the open architecture of ETFs ensures that there is no significant premium or discount to NAV. At the same time, additional demand / supply is absorbed due to the action of the arbitrageurs.

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Ans6.

ETFs derive their liquidity first from trading of the units in the Secondary Market and second through the in-kind creation / redemption process with the Fund in creation unit size.
Due to the unique in-kind creation / redemption process of ETFs, the liquidity of an ETF is actually the liquidity in the underlying shares.

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Ans7.

1. Buying / Selling ETFs is as simple as buying / selling any other stock on the exchange.

2. ETFs allow investors to take benefit of intraday movements in the market, which is not possible with open-ended Funds.

3. With ETFs one pays lower management fees. As ETFs are listed on the Exchange, distribution and other operational expenses are significantly lower, making it costeffective. These savings in cost are passed on to the investor.

4. ETFs have lower tracking error due to in-kind creation and redemption.

5. Due to its unique structure, the long-term investors are insulated from short term trading in the fund.

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Ans8.

Though Close-Ended Mutual Funds are listed on the exchange they have a limited number of shares and trade at substantial premiums or more often at discounts to the actual NAV of the scheme. Also, they lack the transparency, as one does not know the constitution and value of the underlying portfolio on a daily basis.
In ETFs, the number of units issued are not limited and can be created / redeemed throughout the day. ETFs rely on market makers and arbitrageurs to maintain liquidity so as to keep the price in line with the actual NAV.

Comparison of Open Ended Funds v/s Close Ended Funds v/s ETFs:

Fund Size Flexible Fixed Flexible
NAV Daily Daily Real-Time
Liquidity Provider Fund Itself
Stock Market Stock Market / Fund Itself
Availability Fund itself Through Exchange
where listed
Through Exchange where listed / Fund itself.
Portfolio Disclosure Disclosed monthly Disclosed monthly Daily/Real-time
Intra-Day Trading Not possible Expensive Possible at low cost

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Ans9.

A broad class of investors can use ETFs:
The major players in this market have historically been Large Institutional players seeking to Index core holdings or pursue more aggressive market timing and sector rotation strategies. However, since Smaller Institutions and Retail Investors can trade in small lots, they can invest in essentially the same terms as Large Investors.

1. For Retail or Wholesale Investors with a long-term horizon, it allows diversification of portfolio with one single investment. It insulates them from short term trading activity of other investors in the Fund as ETFs have a unique in-kind creation / redemption mechanism. Lower costs of ETFs enhance net returns in the long term.

2. For FIIs, Institutions and Mutual Funds, it allows easy Asset Allocation, Hedging and Equitising Cash at a low cost.

3. For Arbitrageurs, it provides ease with low Impact Cost to carry out arbitrage between the Cash and the Futures market.

4. For investors with a shorter term horizon, ETFs provides access to liquidity due to the ability to trade during the day and at values near to NAV.

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Ans10.

Asset Allocation: Asset allocation managing could be difficult for individual investors given the costs and assets required to achieve proper levels of diversification. ETFs provide investors with exposure to broad segments of the equity markets. They cover a range of style and size spectrums, enabling investors to build customized investment portfolios consistent with their financial needs, risk tolerance, and investment horizon. Both institutional and individual investors use ETFs to conveniently, efficiently, and cost effectively allocate their assets.

Cash Equitisation: Investors typically seek exposure to equity markets, but often need time to make investment decisions. ETFs provide a "Parking Place" for cash that is designated for equity investment. Because ETFs are liquid, investors can participate in the market while deciding where to invest the funds for the longer-term, thus avoiding potential opportunity costs. Historically, investors have relied heavily on derivatives to achieve temporary exposure. However, derivatives are not always a practical solution. The large denomination of most derivative contracts can preclude investors, both Institutional and Individual, from using them to gain market exposure. In this case and in those where derivative use may be restricted, ETFs are a practical alternative.

Hedging Risks: ETFs are an excellent hedging vehicle because they can be borrowed and sold short. The smaller denominations in which ETFs trade relative to most derivative contracts provides a more accurate risk exposure match, particularly for small investment portfolios.
Arbitrage (Cash Vs Futures) and Covered Option Strategies: ETFs can be used to arbitrage between Cash and Futures Market, as it is very easy to trade. ETFs can also be used for cover Option strategies on the Index.

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Ans11.

Dividends received by the Scheme will be reinvested in the scheme. However, the Fund may also decide to distribute dividends to the investors.

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Ans12.

Same rules apply as in the case of buying or selling stocks or mutual fund units. Kindly refer the
respective Offer Document /Key Information Memorandum

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Ans13.

Constituents of an Index are changed as and when Securities in the Index do not match specific criteria laid down by the Index Service Provider or a better candidate is available to replace a constituent. The Index Service Provider usually makes announcements of change well in advance. Once Securities in the underlying index are changed, the Fund would change the Securities in its underlying portfolio by selling the Securities that are being removed from the Index and including those that are included in the Index. This will in no way affect the units being held by an investor, as the units will continue to track the index. The only effect may be on the tracking error of the scheme.
Index changes are usually not so frequent. In India, historically, around 10%of the Index constituents have changed annually which means an index of 50 securities would experience about 5 changes every year.

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Ans14.

Index Futures have gained wide acceptance globally as a tradeable means of shifting exposure to Indices. Index Futures are advantageous when the implied Cost of Carry is less than the actual Cost of Carry. In addition, an investment in ETFs requires investment of the entire notional value, while an investment in Futures requires posting of an initial collateral deposit and then daily Market to Market Margins which represent a small fraction of the notional value, allowing leverage. ETFs are beneficial over Index Futures in many situations:

1. When investors cannot or prefer not to trade Index Futures

2. When cash flows are small and investors do not have enough capital to invest in index futures, as the minimum investment amount required in index futures is very large as compared to ETFs.

3. For longer-term horizons, Index Futures need to be rolled over every month /quarter which has its own risk and costs

4. If regulations prevent investors from investing in Futures;

5. Taxation issues: With Index Futures investors can avail of only short-term capital gains while with ETFs, investors can avail long-term capital gains.

6. If the discount in ETFs is greater than the discount in futures

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