A Peek Into Exchange Traded Funds

Exchange Traded Funds or commonly known ETFs, in their true spirit are mutual funds listed over stock exchanges and hence they derive the word ‘Exchange Traded’ in their name. For many of you, investing in an ETF would sound more like buying a share via your stock broker and may not have bothered to know how exactly an ETF is formed and its associated technicalities. Fair enough, as long as watch is showing the time we don’t really care as to how does the watch shows an accurate time. For others, if they know the mechanics behind a gadget, they feel more confident about the product. The motive behind this article is to decode ETFs so that investors can feel more confident while dealing / investing in them and can hence make the best usage out of them.

 

What is an ETF ?

To put it very simply, an ETF is a fund which invests in a basket of securities based upon the objectives of the fund. The securities can be a group of shares reflecting an Equity Index or a commodity such as Gold. Such a fund is then broken down into units which are then listed on a stock exchange. Unlike a mutual fund whereby investors can generally invest into the fund by placing a purchase request with the respective fund house, ETFs are purchased by placing a buy order on a stock exchange via a stock broker. So if you bought a Gold ETF, you would be indirectly investing into Gold. Similarly if you bought a ‘NIFTYBEES’ ETF, it would provide an indirect exposure into Nifty Index without having to buy shares in exact proportion as in NIFTY Index and thereby adding to the ease of executing an investment. If you read closely, I wrote the words ‘indirect’ in case of ETF investments. For investors who tracks their investments closely, this word would have raised eye-brows. Hence to get more comfort on ETFs, lets try to have a look at how ETFs are created and the structure behind an ETF.

 

How is an Exchange Traded Fund born ?

In order to understand the initiation of an ETF, you first need to understand a couple of parties who join hands to create an ETF :

Sponsor – is an orginator of an ETF. It is generally an Asset Management Company which files the required paperwork with the regulator to create an ETF and prepares for the required infrastructure associated with the ETF. I won’t call sponsor as an owner of ETF, but rather an originator of an ETF.

Authorised Participants (AP) – are big financial institutions who are appointed by the Sponsor of an ETF. AP’s biggest role is to acquire the required underlying shares / securities of an ETF and submit with the Custodian. It then plays an instrumental role in creating a market / liquidity for the ETF shares in the secondary market by selling the issued ETF shares to retail / institutional investors. Further it plays a vital role in making sure that the price of an ETF unit listed on a stock exchange is closely reflective of the underlying securities of the ETF. This is explained more in the ETFs and Arbitrage section.

Creation Units – is a specific minimum number of shares of an ETF in whose denomination an investor can approach to deal directly with the ETF for purchasing / selling ETF shares. Any number of ETF shares less than Creation units are generally bought / sold via a stock exchange. Generally the denomination of a Creation unit can be any where between 50,000 to 500,000 ETF shares. To avoid confusion, . ETF shares are the units of ETFs listed on a stock exchange and do not mean the underlying securities / shares held by an ETF.

Now that we have described a few terms above, lets look into series of event which results into the creation of ETF as we see listed on stock exchange :

1. A Sponsor applies for the registration of an ETF with the regulator. The regulator would make sure that the sponsor is having good financial reputation and ability to manage the ETF. Generally sponsors are big Asset Management Companies / Investment Banks.
2. Once registration is granted, the Sponsor appoints an Authorised Participant (AP) who shall play an important role in the creation of ETF Units.
3. Based upon the investment objective of the ETF, AP shall procure the respective securities from the market and place them with the custodian. In case of a Gold ETF, Gold commodity is purchased and stored with the custodian. In case of an Index ETF, the associated stocks are procured by the AP and stored with the custodian. It is important to stress that there is no cash which is exchanged between the AP and the ETF. The transaction mode is ‘In Kind’. The AP submits the underlying securities to the ETF’s custodian and in return the ETF issues ETF shares to the AP. The issue of these ETF shares to the AP are called ‘Creation Units’.
4. The AP then sells the issued ‘Creation Units’ or ETF shares in the open market. This can follow multiple ways such as private placements with big financial institutions or selling ETF shares to retail investors. It is at this stage that the common retail investors see the ETF shares for the first time.
5. The retail investors can then sell these ETF shares over the stock exchange like any other share. Any buyer would similarly buy ETF shares over the stock exchange.
6. Another alternative available with investors to sell ETF shares is by acquiring minimum number of ETF shares which qualify as ‘Creation Units’. The investor can then approach the respective ETF to sell the ETF shares and in return the ETF shall provide the respective investor the equivalent number of securities which are backing the ETF shares (such as Gold or equity shares). Again it is important to note that there is no cash which is provided on such sale. Hence you may note that the word ‘Indirect’ used in the first paragraph of the article is not scary in case of an ETF.

 

Characteristics of an ETF

A couple of interesting characteristics associated with ETFs are :

1. ETFs are equivalent to shares when being traded on stock exchange. You can buy / sell ETF shares on an intraday basis to take advantage of market volatility of the underlying ETF securities. This is quite a contrast with mutual funds having  similar objective as of ETF (such as index funds). The reason behind this feature of ETF vs  Mutual funds is owing to the valuation model behind these instruments. Mutual Funds are valued at end of the day and do not offer the flexibility of buying / selling on an intraday basis to take advantage of market volatility.

2. Passive Funds – ETFs are mostly passive funds and are framed to track an underlying Index / commodity. Day to day investment management is hence not required for ETFs making them a less costly option (in comparison to actively managed mutual funds) to invest.

3. Demat form – Investors need to mandatorily have a demat account in order to invest into ETF. This unlike a mutual fund whereby an investor does not need a demat account to invest.

4. Stock Broker – As ETFs are bought and sold on stock exchanges, an investor needs to have an account with the stock broker who would place the buy / sell orders on the stock exchange. In return, the stock broker shall charge a brokerage fees from the investor ranging from 0.1% to 0.75%.

5. Cash pile – Unlike Mutual Funds, ETF’s generally don’t sit on cash piles to empower them with the redemption pressures. As you would have noticed in earlier section on ‘How ETFs are Borne’, transactions directly with ETFs are not on cash basis. Hence, they do not maintain big cash piles and hence tend to have a lower Tracking error compared their peer mutual funds.

6. Liquidity on Stock Market – As ETFs are traded on stock markets, their liquidity on the respective stock exchange makes a material difference in their price efficiency. For example, if an ETF is not very liquid on a stock exchange, there would be very little buyers or sellers who would be willing to invest in that ETF. Hence even a small sell order on that ETF would trigger a sharp reduction in the prices of the ETF on the exchange due to limited number of buyers. This point takes us nicely upon Arbitrage Opportunities in ETF.

 

ETFs and Arbitrage

Just like shares being traded on a stock exchange, an ETF’s price on an exchange gets widely influenced based upon the number of buy and sell orders which are in place at any given time on an exchange. If the buy orders are more than the sell orders, the price of a share would increase and vice-versa. Hence there is a chance that an ETF may be quoted on a stock exchange at a price more / less than the underlying securities it is holding. For example, if a Gold ETF has procured 100 crores of gold and is listed on a stock exchange based upon 10 lac ETF shares @ Rs. 100 each. If there is sudden increase in number of buyers of that ETF in the market, the ETF price may increase from Rs. 100 to Rs. 110. This would make the total value of ETF on the exchange to be Rs. 110 crores (Rs. 110 per ETF x 10 lac ETF shares). However, the underlying Gold security with ETF would still be valued Rs. 100 crore and hence would create an imbalance between the actual worth of the ETF (Rs. 100 crores) versus the Quoted value of the ETF (Rs. 110 crore).

It is here where the Authorised Participants come handy. They quickly buy Physical Gold worth Rs. 10 crore from the Gold market and sell it to the ETF and in return get ETF shares worth Rs. 10 crore (remember there is no cash dealing between ETF and AP). The AP then sells these Rs. 10 crore ETF shares on the stock exchange which would increase the number of sellers and taper down the price of the ETF shares till the total quoted value of ETF matches with its actual worth.

Similarly if the price of the Gold ETF on stock markets is less than the physical gold in ETF’s vaults, the AP would buy a lot of Gold ETFs from the stock exchange and sell it to the ETF to get delivery of the physical gold which is in turn sold physically in the gold market. The buying activity of the ETF shares created by the AP on the stock market would increase the number of buy orders and increase the price of ETF.

The AP hence makes sure that (by the above mentioned arbitrage act) the ETF quoted value on the stock market is closely in line with the underlying security of the ETF.

 

Types of ETFs available in India

ETF market in India is still developing in comparison with our western peers. Broadly the following types of ETFs are available to invest in India :

1. Gold ETF : This is one of the most heavily traded ETFs and invest into physical gold as its underlying security. For other options on how to invest into Gold, you may want refer to our article Different Options of Investing in Gold.

2. Index ETFs : These class of ETFs invest into equity shares which replicate an underlying Index such as NIFTY, Bank Nifty, Junior NIFTY, etc.

3. International Indices : Track international Stock market indices such as NASDAQ, Hang Seng, etc. These are getting good attraction these days by investors who want to diversify their portfolio by investing in global equities.

4. Bond ETFs : These ETFs have not yet been formally introduced, but they are planned to be listed in 2012 by NSE. Once in existence, investors would be able to invest in Corporate Bond market via Bond ETFs.

A complete list of ETFs currently listed and traded on National Stock Exchange of India are are follows.

Underlying Asset	Symbol	ETF Name	LTP	NAV
Bank Nifty	BANKBEES	Banking Index Benchmark Exchange Traded Scheme	1,014.36	1,014.04
Bank Nifty	RELBANK	Reliance Banking Exchange Traded Fund	929.9	1,048.61
CNX Infra Index	INFRABEES	Infrastructure Benchmark Exchange Traded Scheme	249	249.54
CNX PSU Bank Index	KOTAKPSUBK	HDFC Gold Exchange Traded Fund	360	355.78
CNX PSU Bank Index	PSUBNKBEES	Psu Bank Benchmark Exchange Traded Scheme	350.1	344.7
Gold	AXISGOLD	Axis Gold ETF	2,752.00	2,734.51
Gold	BSLGOLDETF	Birla Sun Life Gold ETF	2,825.00	2,792.38
Gold	CRMFGETF	Canara Robeco – Gold ETF	2,998.00	2,811.44
Gold	GOLDBEES	Gold Benchmark Exchange Traded Scheme	2,687.30	2,671.16
Gold	GOLDSHARE	UTI Gold Exchange Traded Fund	2,675.00	2,683.16
Gold	HDFCMFGETF	HDFC Gold Exchange Traded Fund	2,763.60	2,736.57
Gold	IDBIGOLD	IDBI Gold Exchange Traded Fund	2,795.00	2,799.81
Gold	IPGETF	ICICI Prudential Gold Exchange Traded Fund	2,764.90	2,753.74
Gold	KOTAKGOLD	KOTAK Gold ETF	2,686.90	2,681.53
Gold	MGOLD	Motilal Oswal MOSt Shares Gold ETF	2,825.00	2,813.79
Gold	QGOLDHALF	Quantum Gold Fund	1,343.00	1,334.33
Gold	RELGOLD	Reliance Gold Exchange Traded Fund	2,616.80	2,607.47
Gold	RELIGAREGO	Religare Gold Exchange Traded Fund	2,767.50	2,757.99
Gold	SBIGETS	SBI Gold Exchange Traded Fund	2,762.55	2,735.03
Government Securities	LIQUIDBEES	Goldman Sachs Liquid Exchange Traded Scheme	1,000.01	1,000.00
Hang Seng Index	HNGSNGBEES	Hang Seng Benchmark Exchange Traded Scheme	1,360.00	1,417.30
Junior Nifty	JUNIORBEES	Nifty Junior Benchmark Exchange Traded Scheme	105.5	105.28
Midcap	M100	Motilal Oswal MOSt Shares M100 ETF	7.68	7.79
Nasdaq100	N100	Motilal Oswal MOSt Shares NASDAQ 100 ETF	138.38	140.79
Nifty	BSLNIFTY	Birla Sun Life Nifty ETF	53.8	52.43
Nifty	IIFLNIFTY	IIFL NIFTY ETF	524.5	523.29
Nifty	KOTAKNIFTY	Kotak Nifty ETF	533.5	531.79
Nifty	M50	Motilal Oswal MOST Shares M100 ETF	70.5	72.23
Nifty	NIFTYBEES	Nifty Benchmark Exchange Traded Scheme	529.65	524.65
Nifty	QNIFTY	Quantum Mutual Fund Quantum Index Fund	531	533.01
Nifty	RELGRNIFTY	Religare Nifty Exchange Traded Fund	488	524.04
Shariah Index	SHARIABEES	Shariah Index	119.85	118.39

* Source NSE website. LTP means Last Traded Price as on 10 April 2012.

It would be interesting to note that in the above table there is a slight difference between the NAV & actual price of the ETF. NAV represents the actual worth of the ETF. LTP is the quoted price of the ETF unit. It is generally common that these difference are within 1% of the value. Any difference beyond this percentage level would trigger APs to take advantage of the difference.

 

Conclusion

You would probably now have got some idea about how ETFs function and that they are an efficient and effective way to gain exposure of certain asset classes or asset mix without having to acquire that asset class / mix. Hopefully in times to come we would get more types of ETFs being listed on Indian markets providing investors the opportunity to diversify their portfolio with minimum cost and greater ease.

If you need any clarifications on ETFs, please feel free to ask in comments section of this article.

Related Posts:

• Please Do Not Invest in Equities
• Different Options of Investing in Gold