All you want to know about exchange-traded funds

In the1990’s in US, there was this aha movement when James Carswell, who was the election manager for Bill Clinton, said that if he was to be reborn, he wanted to be a bond market because bond market dictated policy about the deficits in America, what the tax rate should be in America, what the inflation rate should be in America. It was more important Congress, more important than the president, the bond market controlled the financial economy.

Switch forward to 2010 onwards, the new financial kid on the block is exchange-traded fund (ETFs). They are very important and increasingly dynamic force that shapes financial markets. It can cause rapid movements in various assets and commodities—gold, silver or equities.

In an interview with Ramesh Damani, Balaji Gopalkrishnan, MD, Credit Suisse, David Abner, Director, Instl ETF Sales & Trading and Nitin Rakesh, CEO and MD, Motilal Oswal Asset Management, speak about ETFs.

Also read: Indian ETFs in US score great results, says WisdomTree AMC

Below is the script of the interview. Also watch the accompanying videos.

Damani: What is the difference between a close ended fund that trades on the exchange and an ETF?

Abner: They both trade on exchange. A close ended fund will not have a creation and redemption mechanism that enables the fund to issue new shares. So, a close ended fund starts out with an issuance of shares and those shares are generally fixed for the life of the product, except for secondary offering and things like that.

An ETF has a function called continuous issuance. So, everyday in the life of an ETF authorised participants can create or redeem shares that they have. What this does is critical because it enables the ETF to trade right around net asset value (NAV) because there is an embedded arbitrage mechanism. It is one of the last remaining pure arbitrages, if you think about it. When the basket in ETF is trading at the same time, there is a pure arbitrage between those two products.

Damani: Sophisticated enough for Indian investors to understand the difference between a close ended fund and an ETF, can you give an example?

Rakesh: I think the Indian investors are very use to close ended funds till about 15 years ago. One of the reasons why close ended funds became out of fashion was primarily because you would invest in them and had no ability to take your money out, unless you could find a buyer on the exchange. On the exchange, when you would try to sell the fund, it would typically trade at 20-30-40% discount to the NAV which effectively means that they are loosing fair amount of value that has being created in the fund or even if it is not being created, you are still using value. That is why we came out of fashion.

What ETFs does really is it blends the listed feature of a close ended fund, but gives the ability of an open ended fund to then create and redeem units on a daily basis just like to have on the mutual fund side. Because you can sell and buy ETFs units on a day to day basis, this 20-30-40% discount shouldn’t exist and does not exist. Yes, you will still have a 1-2% difference between ETF price and the NAV. But that is a function of market supply demand.

For example, if you take any Nifty ETF or midcap ETF, if the NAV of the ETF is Rs 8 because you know the underlying 100 stocks and you know at what price they trade at and what is the composition of that basket is, and you see the market price to be Rs 9 then there is a Re 1 as we call it free lunch available on the table. This is pure arbitrage, risk free arbitrage. You could easily buy one and sell the other. That feature basically lends the ETFs to be effectively tracked as close as possible. That is pretty much what ETF as an innovation has managed to do.

Damani: Theoretically that is true, of course that any arbitrage should be discounted away by the market participants. In the US itself, a lot of the ETFs have a huge tracking error. For example, USO oil fund. It traded at 62% discount to its asset for some reason, or a banking fund. It used to be a short ETF fund and actually it underperformed the long fund, when the market was going down. Why is the tracking error then? Is it for specific type of fund or is it across ETFs?

Gopalkrishnan: I will just give a clarification on United States Oil Fund since you have asked, USOs is not an equity under liked product, it is product that uses futures as an underlier. In the purest form, it is not defined as an ETF. Many purists say it is not a 40 act fund or SEC regulated fund. Even though SEC blesses it and has to be approved by it, it is not a pure ETF in the purest sense. And it doesn't track oil and it tracks the futures on oil. So, the supply and demand on the futures over the spot price over the ETF is what creates the opportunity. And on a fungiblity basis, most of the stock based ETFs are completely collapsible. On a commodities basis, it may not be, especially the ones that track futures or options.

On the short side, most of the short ETFs have a daily resetting provision which means they track a compounded daily return. It does not have to have a reality of A point versus point B.