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Concepts & Tutorials

Exchange Traded Funds (ETFs)

You are perhaps familiar with mutual funds and the fact that you can purchase and sell units of the mutual fund through any distributor. When you do so, you buy directly from the fund and sell to the fund when you redeem units. You can’t buy your units from another person (like me for instance) or sell to me.

This creates a number of issues – firstly that everytime a purchase is made, commissions are paid out, and funds will sometimes charge exit loads to discourage early redemptions, so money needs to be paid on a sale as well. Unfortunately this doesn’t make too much sense – if you want to sell and I want to buy, why should we be charged any load? It’s just a transfer of ownership! But regular mutual funds don’t allow such a transfer.

Also fund NAVs are only released at the end of a day, and you have to enter your purchase or sale order earlier – so you’re buying or selling “blind”. And finally, there are some funds which are not redeemable when you need them – many closed ended funds don’t allow redemptions every day, just a few days a quarter.

Enter the exchange traded fund (ETF)
To solve the problems listed above, mutual funds may choose to list the units of their mutual funds on a stock exchange. So you and I can buy or sell through a stock broker (online or offline) and get units into our demat accounts. ETFs are widespread and follow different philosophies – the most common of them are index funds (which track a particular index) and Benchmark is a fund house that only has ETFs.

How do ETFs work?
What the mutual fund does is that it appoints market participants or market makers to transact on the exchange. Retail individuals like you and me can buy through our brokers – and we can bid or ask for units at market prices. These prices are usually close to the NAV of the fund – if the market price is lower than the NAV, a market participant will buy from the exchange and sell to the fund directly, making the arbitrage difference as profit.

Can you buy directly from the fund?
The fund may dictate that only market participants may buy or sell directly (most closed ended funds are like this) or that you can deal with the fund only above a certain number of units, called the creation unit. The limit is usually quite high – 500,000 units or so, which is out of the reach of small retail investors, but in the realm of commercial market participants.

This means that if you want to deal with the fund directly you have to deal in multiples of the creation unit size.

Also, market participants don’t give money to the fund – they buy a “creation unit” from the market and give it to the fund. A Benchmark NiftyBeES ETF participant will thus give a basket of Nifty Stocks (in the numbers specified by Benchmark) in a demat transfer to the Nifty BeES account, and Benchmark will give them that many Nifty Bees ETF Units in exchange.

What about loads and charges?
As you buy directly on an exchange, funds don’t charge you loads. You may of course pay brokerage to your broker, and further fees such as service tax, transaction tax etc., but these usually add up to less than 1% (compared with a typical equity fund load of 2.25% – note, no longer applies since 2009). But you must remember that there could be a difference in the NAV and the market price – the exchange price is dictated by supply and demand, which can make it a significant discount (or premium) to the NAV. In fact some ETFs trade at deep discounts to the NAV, because they must be held for a long period by a buyer before the fund will redeem (even for market participants). So the discount works against you when you’re selling.

Management fees are directly charged to the fund. These can be really small, because the fund manager expertise usage is low – Nifty BeEs charges as low as 0.5%. Gold ETFs, though, might charge more due to the handling charges of gold itself. Gold ETFs trade at a discount to the underlying Gold value due to these fees.

On the other hand Nifty BeES might trade at a premium to the corresponding Nifty Value because of dividends. (details below)

Which fund do I buy?
You can buy individual stocks on an exchange. But if you wanted to buy an Index, such as the Nifty or the Sensex, you have to buy ALL the stocks of the index, in the corresponding weightage. So you may need to buy 1.6 shares of Reliance, 1.2 or ONGC etc – but obviously this does not work too well for you, since you can’t buy fractional shares, and buying at a higher multiple can involve lakhs of rupees! Plus, you have to keep shifting stocks around because the weightages change daily.

A cheaper way is to buy Index futures – these are derivatives that will allow you to purchase or sell the Nifty or the Sensex, but on a future date. Unfortunately, such derivatives are only available for the short term – a maximum of three months. Additionally, index futures have a huge margin – Rs. 40,000 or above – per contract.

ETFs are very good for index purchases. Firstly, they are much cheaper than buying stocks in the index or buying futures. The Nifty BeES by Benchmark fund, for instance, costs about 1/10th the value of the nifty (per unit), which is around Rs. 420 today. The fund management is passive – almost entirely computerised – which means fund management charges are very low (less than 1%). Add that to the fact that your entry load is nil and brokerage charges are very little, you can trade an exchange traded index fund and reap benefits of overall market growth.

There are ETFs for the Nifty, the Sensex, Nifty’s bank index and a few other indices.

Remember though, that not all ETFs are available on all exchanges. The Nifty BeES for instance is traded only on the NSE, and the Sensex based ETFs are traded entirely on the BSE.

Dividends
Funds declare dividends as usual, and this adds to your return. Because the NAV is close to the index value, funds have to buy and sell and this can generate substantial profits, which may be distributed as dividend. In Index based ETFs, this is truly a case where dividends may reduce NAV but very soon the NAV goes back to a value close to the Index peg.

For instance, Nifty BeES declared a Rs. 8 dividend recently – that should have created a difference of Rs. 8 between the index value (Nifty divided by 10) and the fund NAV. But obviously market arbitrageurs would use the difference for profit, so the price on the exchange remained the same. That means you got Rs. 8 per unit and the price remained stable, which is a Rs. 8 profit in your pocket.

What are the current ETFs for Indices?
Nifty BeES (NSE Nifty), Prudential SPiCE (Sensex) are a few – you can find a number of them at the Benchmark site.


More reading
Benchmark ETF FAQs
Rediff article on ETFs

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  • Anonymous says:

    >Yes Deepak ETFs are the way to go. I’ve been researching on this. Of the 2 ETFs – Nifty BeES and Spice, MutualFundsIndia.com shows Spice 1 year returns as 46% and Nifty BeES’ returns as 36%. But AUM of Spice is only 77 lakhs compared to 145 crores of the other. Also daily traded volumes of Spice is very low.2 week average traded quantity is 217 while Nifty BeES has healthier volumes.Why such a difference?Which one would you recommend?

  • Deepak Shenoy says:

    >Hmm. The Sensex is different from the Nifty but I get a 42% 1 year return on the NiftyBeES (from valueresearchonline.com) Also note that there was a Rs. 8 dividend in march which might have not been considered by mutualfundsindia.com

    I like hte Nifty more – it’s not as heavy on certain sectors as the Sensex. True the sensex has grown more than the nifty but the Nifty’s a better indicator of the economy (in my opinion). So I’d go with Nifty BeES.

  • Anonymous says:

    >A correction – Nifty BeES 1 year returns is 39% not 36. 3 year returns of both funds are comparable 37 and 32 respectively. What about the differences in AUM and volumes?Is such low AUM and low traded volumes good?If returns of Spice are better why such a low investor interest in it?

  • Deepak Shenoy says:

    >No, you’re right – low aum and low traded volumes ARE bad. People just haven’t warmed up to ETFs yet. But I think going forward these will be the smartest investments….

  • Vivek Venugopalan says:

    >Deepak:
    If a market participant buys from the fund during IPO stage, would that be considered as an offmarket transaction with associated tax implications?

  • Deepak Shenoy says:

    >Vivek: Mutual funds have no “off market” concept – as a non equity mutual fund, no STT will be applicable, and the tax implications are exactly like trading a debt fund – short term = added to your income, long term = 10%.

  • Prabhu Shankar says:

    >Enjoyed reading your blog…

    Regards,

    Active Daytrader
    Livenewss.blogspot.com