Saturday, July 30, 2005

ETF


Introduction :

What do VIPERS, SPIDERS, WEBS, DIAMONDS and CUBES have in common? Well, they are all Exchange Traded Funds.

VIPERS stands for Vanguard Index Participation Receipts), SPDRs is Standard & Poors Depository Receipts, pronounced "SPIDERS"), CUBES is the name given for QQQ (called so because of its three 'Q's), and tracks the technology-laden NASDAQ 100 stocks.

Also, they are a new addition to the vocabulary of the Indian investor in the domestic financial markets and a new species in the kingdom of the innovative financial instruments that have become buzzwords in the turbulent stock markets. But ETFs are a novelty only in India.

Exchange Traded Funds have been in vogue in the global financial markets, especially the US financial markets for a long time now and have $110 billion locked in assets under management.

An index of their popularity can be gauged from the fact that about 60 per cent of the trading volumes on the American Stock Exchange comes from ETFs.

It is only now that these funds are catching on in the domestic mutual fund market in Inida. UTI has launched its own ETF called SUNDERS, after Becnhmark's BeES and Prudential ICICI's SPIcE.

ETF: The History

Exchange Traded Funds came into existence in 1993 when, State Street Global Advisors, together with the American Stock Exchange, developed and launched the ETF market. The name of the product was SPDRS.

SPDR, which is benchmarked against the S&P 500 Index, continues to be the most successful product with over $22 billion in Assets Under Management. It currently enjoys tremendous liquidity, averaging close to $1 billion in shares changing hands every day on the American Stock Exchange. In fact, it consistently ranks as one of the most active securities on the AMEX.

In addition to launching the SPDR, State Street Global Advisors and the AMEX also launched the Dow Diamonds in 1998, benchmarked against the Dow Jones Industrial Average. That year they also introduced the first sector ETFs, the Select Sector SPDRs, benchmarked against the nine sectors making up the S&P 500 Index.

In 1999, they introduced the first ETF in Asia and currently they are doing the same in other major markets around the globe. Now subsequent to the roaring success of the ETF market, more and more complex instruments revolving around the ETFs are coming into being.

Such an innovation are options and futures on ETFs. On November 18, 2002, EUREX (European Exchange) launched Europe's first futures and options on the most liquid ETFs.

Concept

An Exchange Traded Fund, as the name itself suggests; is a financial instrument, tradable on a stock exchange, that invests in the stocks of an index in approximately the same proportion as held in the index.

An ETF is a hybrid financial product, a cross between a stock and a mutual fund. Like a stock it can be traded on a stock exchange, and like a mutual fund it behaves like a diversified portfolio.

In many ways it is an index fund, with a few subtleties that put it in a separate league. Unlike an open-ended index fund, where an investor purchases units from the fund itself and to redeem them sells the units back to the fund and thereby expanding or shrinking its corpus on each entry or exit from the fund, in an ETF is listed on an exchange ensuring that the entry or exit of investors has no effect on the fund corpus. An ETF is transacted through a broker and held in dematerialized form. An ETF is different from an Index Fund in another manner.

Availability of real-time quotes is another feature present in an ETF but absent in an Index Fund where the previous days NAV is applied for buying or redeeming. This feature makes the trading of the ETFs possible.

Much like the units of a mutual fund the ETF too, is divided into units called a "creation unit". The name emanates probably from the process through which one comes to acquire these units. The ETF units when purchased from the fund house are purchased by surrendering the underlying stocks in of the index the ETF tracks and thereby 'creating' the ETF unit.

How ETFs are traded

The trading of the ETF is based on a well-known mechanism called arbitrage. But first, let us see how one can buy an ETF. There are two ways in which one can buy an ETF. One is through the market and the other is through the fund house that has issued the ETF. Now for the pricing mechanism: if the demand of the ETFs in the markets soars, the ETF would start trading at a premium from its intrinsic value, which should be equal in proportion to the index that it is charting. This premium would make the buyers go to the fund house where they would have to redeem their shares in the proportion held under each unit of the ETF. Such units that are bought directly from the fund house are called "creation units". But usually the lot size in which one can buy creation units is so high that only an authorized participant (market maker) or institutional investors may have the wherewithal to buy these. In such case the retail investor would have to go to the market itself to buy the units of the ETF, the decision in turn depending on the expectations of the future price movements of the ETF. In case of redemption in the market, the seller would get paid in cash and in case the fund units are taken to the issuer, the seller would get paid in kind that is the underlying shares that make up the index. ETF trading also opens up the flood gates for some more complex trading arrangements like arbitrage between the cash and futures market or simply put - short selling. But there is a hitch as far as the Indian capital markets is concerned: "shorting" is not allowed. As a proxy, one can borrow the units but that mechanism is not very efficient, as the cost of borrowing happens to range between 12 to 18 per cent depending on one's creditworthiness. Given beside is a chart that explains the trading mechanism

Advantages of ETFs

Tradable and Diversifiable: The ultimate selling proposition of an ETF lies in its twin feature of being tradable and diversifiable. One can trade a stock but then it is not diversifiable. Or, one can buy a mutual fund and thereby diversify but then the mutual fund would not be tradable. Alternatively, one can diversify one's risks by holding a portfolio of stocks and trade them but that would be too much of a botheration for the lay investor. This conflicts are reconciled by an ETF that is at once tradable and is a diversified portfolio too. It is these two feature, working in tandem, like the twin blades of a scissor that make it a financial product of choice.

Low cost: Just like an Index-Fund an Exchange Traded Fund does not have to incur any costs on account of active fund management because the fund is passively managed. As the ETFs are listed on the exchange, the cost of distribution is low. Furthermore, exchange traded mechanism reduces minimal collection, disbursement and other processing charges.

Transparency: Just like the index fund, the portfolio of an index fund has no mystery to it. Everybody in the participating market is aware of the stocks that it is tracking and therefore need not worry about a change in the stocks being traded in.

Makes multiple trading strategy possible: As has been said earlier, ETFs have the utility of doubling up as arbitraging instruments between the futures and cash markets. It also helps in equitizing cash, i.e., changing cash into equities, at a low cost.

A Bear market friend: In a volatile stock market, an ETF might become an instrument of choice as it is not expected to be as volatile and yet may be traded. This is borne out by the fact that the assets of US ETFs have grown from $ 96 billion in January 2003 to $118 billion in May 2003.

Disadvantages of ETFs

Absence of prior active market: In India ETFs being a new instrument, there is no existing market that one could swim into immediately after buying the product. So for the liquidity to be reasonable, a large number of investors would have to buy into the idea to make adequate liquidity possible.

Large Investments: In order to deal directly with the fund houses large capital investments are required. For example in the case of Nifty BeES, a minimum creation unit size of 20000 units is required that would involve lakhs of rupees in investment. This makes ETFs a market where the institutional buyers and sellers become the big fish.

Broker Charges: Broker charges have to be paid anyway when trading in ETFs. This can be minimized by trading long but the very charm of ETFs is destroyed because it is meant for being traded more often than an index fund.

Premiums and discounts: An ETF might trade at a discount to the underlying shares. This means that although the shares might be doing very well on the bourses, yet the ETF might be traded at less than the market value of these stocks.

Does not facilitate "rupee cost averaging": An ETF is not appropriate for those investors who want to operate on the strategy of "rupee cost averaging". This is because investors investing some money into ETFs every month would have to incur brokerage costs that are not to be incurred in case of mutual fund units until and unless the scheme carries an entry load

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