Time to look at ETFs again

If you have gone through life without developing even a nodding acquaintance with ETFs (E-what?), you would have missed nothing so far.

ETFs, or exchange-traded funds, haven't exactly set Dalal Street on fire. There are five of them around -- two of them having made a debut in recent weeks -- and collectively they trade barely a crore's worth daily.

But things may be about to change. With the markets into a bull run, the indices are looking perky. Since ETFs are basically index-driven -- in fact, they are like listed index funds that can be traded on exchanges -- ETFs have shown good asset growth.

In the last three months, for example, Junior BeES -- which tracks the S&P CNX Nifty Junior index of mid-cap stocks -- was among the Top 5 equity funds, posting a return of 42.38 per cent.

Reason two, from the investor point of view, is that there is no NAV penalty. Unlike mutual funds, which declare net asset values at the end of the day, ETFs can be bought or sold at very fine spreads above or below their dynamic NAVs through the day.

Thirdly, the recent ETF entrants seem to be getting their basics right. UTI Mutual Fund's newly launched Sunder ETF is becoming increasingly liquid and currently accounts for the bulk of daily ETF volumes.

Benchmark's Liquid BeES, on the other hand, is a money market ETF that should interest investors who want temporary parking places for money.

But are these reasons enough for you to invest in a funny animal like ETF, which seems to be neither fish nor fowl? What, anyway, are ETFs? Are they more like shares or mutual funds? (Answer: Both, they have to be traded like shares, but they are actually index-based units).

Are they more like listed closed-ended funds, or can one redeem units with the asset management company that issued them? (Answer: They are like listed funds, but they more closely follow the underlying NAV in pricing.

They can be sold back to AMCs, but at a huge discount. So you would be better off selling them in the market.)

ETF key stats
Launch date	Nifty BeES 16-Jan-02	Junior BeES 14-Feb-03	Pru Spice 9-Jan-03	UTI Sunder 11-Jul-03	Liquid BeES 16-Jul-03
Underlying index	Nifty	Junior Nifty	Sensex	Nifty	None
Corpus (Rs crore)	8.95	1.24	21.32	390.00	10.00
Daily traded vol (Rs lakh)	18.06	0.31	4.90	84.02	0.29
Avg. prem/disc. to underlying since launch	0.68	-0.264	-0.264	-0.69	-
Latest NAV	122.00	204.00	38.295	118.81	1000.00
Valuation of units	1/10 of underlying	1/10 of underlying	1/100 of underlying	1/10 of underlying	-
Minimum lot size	1 unit	1 unit	1 unit	1 unit	1 unit
(NAV for Nifty BeES and Junior BeES is inclusive of dividend of Rs 3 and Rs 2,5 per unit respectively)

Just like an index fund...
So where does that leave you as an investor? The simple answer is: Just like you don't need to understand the principles underlying internal combustion engines to drive a car, you need not understand the complicated back-end mechanisms of ETFs to invest in them.

Put simply, you need to think of ETFs as listed index funds without some of the negatives of the latter.

The fundamental reason why one should look at ETFs is the same as why one should look at index funds. In India, index funds have had a less than exciting life so far, with 22 funds accounting for a collective Rs 824 crore (Rs 8.24 billion) corpus, or barely six per cent of the assets managed by equity funds.

As index funds are passive investment vehicles, this suggests that investors in India have better faith in active fund management -- a faith that has not been entirely misplaced so far because many funds have indeed outperformed the indices.

The numbers support them. In the last three years, actively-managed equity funds posted average returns of -2.46 per cent, beating the Sensex (-8.76 per cent) and Nifty (-6.84 per cent).

But globally, the majority of fund managers underperform. In the last 20 years, 85 per cent of actively-managed funds underperformed the S&P 500 index in the US. Not surprisingly, investors preferred the passive safety of low-cost index funds.

Since ETFs have index stocks as underlying assets, they have caught on like wildfire in the west. ETF assets have grown over 350 times over the last decade, from $465 million to over $167 billion in June 2003.

In India, however, the reverse has been true. They have been damp squibs, just like index funds. Says A K Sridhar, president, department of fund management, UTI Mutual Fund, "ETFs have not grown in a big way till now primarily because people have not understood the product."

That's one reason why the liquidity in most ETFs is still quite low. In fact, even elsewhere in the world, it took a while for investors to understand the virtues of ETFs.

Between 1993 and 1998, ETF assets had grown only to $17 billion. But in the next five years, the corpus suddenly bloated 10-fold.

Will this happen in India, too? Some fund managers privately agree that their recent record partly because they invested in areas of outperformance when the indices were mostly range-bound.

However, when the markets see a more broad-based rally -- as they are witnessing now -- the indices themselves will tend to rise, making it more difficult for fund managers to repeat the feat time and again. Index funds and ETFs should, therefore, find favour with investors once they begin to understand this.

There are already signs of this happening. When the country's first ETF made its appearance in January 2002 (the Benchmark Nifty BeES, based on the Nifty index), it garnered a meagre corpus. It's still low at just Rs 8.95 crore (Rs 89.5 million).

The daily average turnover is a poor Rs 18 lakh (Rs 1.8 million). The next fund did better. Prudential ICICI's Spice (based on the BSE Sensex) has a corpus of Rs 21.32 crore (Rs 213.2 million), but daily average volumes are even poorer at Rs 490,000.

Third time wasn't lucky either. The Junior BeES (short for Benchmark Exchange-traded Scheme), based on the Junior Nifty, also has a fairly small corpus and weak trading.

If none of the old BeES are buzzing yet, the UTI Mutual Fund's Sunder (a convoluted acronym for S&P CNX Nifty UTI Notional Depository Receipts) has kicked off with a sizeable initial corpus of Rs 388 crore (Rs 3.88 billion), clocking daily average volumes of about Rs 84 lakh (Rs 8.4 million) on the NSE.

Like BeES, Sunder also offers an easy way to invest in a well-diversified portfolio of stocks as the Nifty, on which it is based, is well diversified across sectors and companies.

Sridhar of UTI Mutual Fund says the fund is committed to developing Sunder further. To make the fund liquid, UTI has roped in 27 authorised participants who will act as market- makers.

"We have made sure that all authorised participants have a dedicated team to explain the product to retail customers and also provide liquidity support on a daily basis," says Sridhar.

All APs have to trade at least 2,000 units a day as per the conditions laid out by UTI. The fund has roped in large institutional investors in equities like LIC, Bank of Baroda, IDBI, Punjab National Bank and Union Bank to participate in this scheme. "This should ensure that there is enough liquidity," says Sridhar.

Meanwhile, a buzz is developing around Benchmark Mutual Fund's new BeES, christened Liquid BeES, and positioned as a cash-management product.

Says Nikunj Modi, assistant vice-president (retail sales), Refco Sify, a broking firm: "Money-market ETFs should serve as a great boon to equity investors to earn a return on their surplus cash."

Unlike other ETFs, Liquid BeES is not based on any index. Instead, the scheme invests in floating-rate instruments -- mainly floating-rate debt and short-dated debt securities.

Currently, money market instruments give returns in the range of 4-5.5 per cent. Liquid BeES is for investors who trade actively in stocks.

When active investors in equity run up short-term surpluses during the course of trading, under normal circumstances these funds remain idle with the broker until the investor decides to buy stocks again or pull the funds out completely.

Since Liquid BeES will be listed and traded on the stock exchange, it is subject to the same T+2 settlement cycle that governs the delivery of regular shares.

So an investor can place a buy order for Liquid BeES as soon as he places a sell order on the equity shares that he holds. This way he can earn a small return as Liquid BeES units appreciate (by a minuscule amount, no doubt) even during the intervening period.

Given that bank fixed deposits are not too liquid -- most of them involve a minimum lock-in period of seven days -- money-market mutual funds are better options. Liquid BeES scores over regular liquid mutual funds and money-market mutual funds for the convenience it offers.

The only thing that can really eat into the fund's returns is the 0.5-1 per cent brokerage charges incurred by investors who may buy Liquid BeES.

This makes it a no-gain option if the investment is not for a longer period. But Sanjiv Shah, executive director, Benchmark Mutual Fund, is optimistic that brokers will waive broking fees for Liquid BeES units to make it attractive for investors.

"Several brokers have agreed to waive the brokerage already," says Shah. "Additionally, the scheme would benefit brokers, as they can then directly sell units in the markets to match the cash required to purchase shares," he adds.

Add to this the recent performance of Junior BeES, and the picture looks even brighter. In the last three months, Junior BeES, the only mid-cap index fund, was among the Top 5 equity funds, posting a return of 42.38 per cent.

"We expect Junior BeES to attract more participation as it has been the best performer among all equity funds in the last quarter," says Rajan Mehta, executive director, Benchmark Asset Management Company.

Why aren't ETFs selling all that well then? According to Mehta, "the number of ETF products in the market has to increase for it to become popular."

The ABC of ETFs

First things first. If you want to buy ETF units, you go to your broker, not your mutual fund distributor. There are no forms to fill. You just tell your broker and he will buy it and credit the units to your demat account. That makes them like shares, but their real nature is that of an index fund.
ETFs are index funds in the sense that they, too, track a specific index, with their portfolio replicating the stocks that make up that index.
The difference is that ETFs are listed and traded on stock exchanges. And you can't sell it back to your mutual fund, unless you want to take a huge discount. Asset management companies usually charge a hefty load for buying back EFT units to encourage you to buy and sell them on the exchange.
If this makes ETFs sound suspiciously like those closed-ended funds which traded at huge discounts to NAV, rest easy. This doesn't happen due to the unique manner in which ETF units are created and redeemed.
Unlike closed-end fund where units, once issued, remain static till the fund offers to repurchase or redeem them, the number of units in an ETF scheme keep fluctuating.
Instead of a one-time initial public offer, an ETF creates and redeems units continuously through designated institutions called "authorised participants."
In fact, the IPO happens only for APs. They invest in the basic units before making a market in them by offering two-way quotes for investors who want to buy or sell.
However, they don't pay money to buy these units from the fund. They exchange the underlying shares in the index in lieu of the units allotted.
In short, the fund takes in a basket of Nifty stocks in designated quantities from APs, allots them units in return, and these units are in turn bought and sold by retail and other investors. When an AP wants to redeem his units, he can return them to the fund in exchange for his basket of index shares.
The net asset value of an ETF, expressed on a per unit basis, is the value of the underlying components of the benchmark index held by the ETF, plus the accrued dividends, less the accrued management fee.
Although the price at which an ETF trades is subject to the same market rules of supply and demand as are ordinary shares, the creation and redemption process described above ensures that the price trades very close to the NAV.
Any discrepancy can be arbitraged away. Since ETFs can be traded through the day - unlike index-funds that can be bought and sold only on the basis of the day's closing NAV - they tend to track the index much more closely.
In technical terms, the "tracking error" in an ETF is usually significantly lower than that seen in index funds, since funds allot units for consideration in kind. And this money has to be invested in index stocks at a later date and time.
Unlike index funds, ETFs do not need to hold much cash. Expenses such as brokerage are eliminated completely. Besides, there is a minimal impact cost since ETFs do not buy stocks directly from the market.


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