What are Exchange traded funds (ETF)?

By: Aishwarya Agarwal and Avinash Ghalke

Exchange-traded-funds or ETFs are investment funds that trade on a stock exchange. The underlying investment funds are generally invested in stocks passively mirroring the composition of indices. There are also bond and commodity ETFs now becoming available as the ETF product offering has gained traction since early 2000s. Eg: A Nifty 50 ETF will have the underlying funds that are identical to the Nifty 50 index. ETFs are primarily bought to get benchmark market returns. It’s a great product to buy, especially in India where the market returns (Nifty 50) have averaged around 13% p.a. (annual compounding) over the last 15 years.

In India, ETFs are structured under the mutual fund umbrella as a type of Open-Ended Mutual Fund scheme, with a significant difference. ETF units can be traded over a stock exchange at any point during the span of trading hours and are held in your demat account after settlement. As a result, ETFs come only with expenditure on the brokerage fee whereas mutual funds also charge commissions and other fees. The issuance/redemption of ETF units may carry some costs — but an ordinary retail investor who only trades in and out existing units on the stock exchange would only bear the brokerage charges and impact cost.

Exchange-Traded-Funds have:

  • Lower Fund Management Fees than most mutual funds. MF expenses are 1-2%.
  • No Trailing Commission for Distributors in ETFs as they are traded on the exchange (unlike in mutual funds).
  • No losses due to taxation on Dividend Pay-Out. (Dividend based debt Mutual Funds have a dividend distribution tax of 28.84% on the dividend paid out to investors).

ETFs in India are listed on both the NSE as well as the BSE. To be able to purchase an ETF, one must have a demat account and a depository account (with NSDL or CDSL) linked to it. In a conventional pattern, one would have to set up a demat account by going through the various stages of documentation either with their bank (that have a securities trach) or with any other company serving as a broker in the market.

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Like all equity investments, there are certain risks associated with ETFs. These generally include:

  • Not out-performing the index as ETFs usually track the index itself.
  • Lacking liquidity and market depth in case of certain lesser traded ETFs.
  • In case the index falls, ETF returns fall by roughly the same amount.

However, such risks exist in all equity asset classes. In general, since ETFs track benchmark indexes, they usually give good returns to investors in the long run.

KEY PLAYERS IN THE EXCHANGE TRADED FUNDS (ETF) MARKET

ETF Sponsors

The sponsor creates and administers the Exchange Traded Funds. The sponsor is responsible for the selection of the underlying index and authorized participants (AP) associated with the ETF. The sponsor issues ETF shares in lieu of the shares deposited by the AP.

Authorised Participant (AP) or Market Maker (MM)

APs/MMs are large institution players. They play a primary role in providing liquidity for secondary sales and in creation/redemption of the ETF units. When new ETF units are required to be created, the AP buys the shares that make up the underlying index and deposits them with the sponsor. In turn, the AP collects the ETF units. The sponsor can appoint multiple APs for a given ETF.

Investors

Investors could be individuals or institutions that trade in the ETF units. The smaller players trade in the secondary market. On the other hand, larger players generally trade ETF units in the primary market or through “in kind” operations. Investors may use ETFs for investment, trading or arbitrage.

Creation and Redemption of ETF Units

Source: Tavaga Research

TRANSACTING ETF UNITS

Buying ETF units

One way to acquire ETF units is purchasing them in the secondary markets. Similar to stocks, these can be purchased from other investors who are willing to sell. This mode of purchasing is true for all kinds of investors in the ETF.

However, large investors like authorized participants and institutions can acquire ETFs units through a process called “in-kind” creation. In this, the large investors deposit the shares that constitute the index, to the sponsor of the ETF fund. The sponsor in turn issues the ETF units termed as creation units. This is similar to the shares issued at the time of the IPO. However, the “in-kind” creation process can happen multiple times as long as the investors deposit the shares of the underlying index.

Selling ETF units

One way to sell ETF units is selling them in the secondary markets. Similar to stocks, these can be sold to other investors who are willing to purchase. Additionally, large investors can sell ETFs units through a process called “in- kind” redemption. In this, the large investors deposit the ETF units to the sponsor of the ETF fund. The sponsor, in turn, returns the shares that constitute the underlying.

The number of outstanding ETF units is not limited. ETF units are continuously created and redeemed based on investor demand.

Net Asset Value (NAV) of ETF

NAV of the ETF is the total value of the assets in the fund, including the underlying securities and cash, excluding the liabilities and dividing by the number of ETF units outstanding. The NAV of the ETF is primarily used for accounting and measuring the premium/ discount with respect to the price. The redemption mechanism of the ETF ensures that the difference between the NAV and price is minimum. The price of the ETF should generally move around the NAV of the ETF, otherwise it would spark arbitrage opportunities from Authorized Participants.

MEASURING PERFORMANCE OF ETF

Tracking error

The goal of an ETF is to track the performance of the underlying benchmark. The tracking error is a measure that looks at the deviation of ETF returns from the benchmark returns. Lower the tracking error better is the replication of the benchmark returns.

Expense Ratio

The ETF is passively managed since only the securities of the underlying index have to the replicated in the fund portfolio. When standard indices (like Nitty, Sensex etc.) are used, then the overhead is just the administrative cost of purchasing securities and maintaining the portfolio. Hence given a particular benchmark being tracked, lower the expense ratio, better for investor returns.

A list of ETFs in India, along with their performance:

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