Exchange Traded Funds

Akshita Jain FMS | 2012

A brief study on the Exchange Traded Funds and the opportunities in the Indian market

Table of Contents
What is an ETF................................ ................................ ................................ ................................ ... 1 How does an ETF work? ................................ ................................ ................................ ................. 1 Advantages & Disadvantages of ETF................................ ................................ ............................... 2 Types of ETF ................................ ................................ ................................ ................................ ...... 6 Index ETFs................................ ................................ ................................ ................................ ...... 6 Commodity ETFs ................................ ................................ ................................ ............................ 6 Bond ETFs ................................ ................................ ................................ ................................ ...... 7 Currency ETFs ................................ ................................ ................................ ................................ 7 Actively Managed ETFs ................................ ................................ ................................ .................. 8 Exchange Traded Grantor Trusts ................................ ................................ ................................ .... 8 Leveraged ETFs ................................ ................................ ................................ .............................. 8 US ETF Market................................ ................................ ................................ ................................ . 10 ETF vs Mutual Funds ................................ ................................ ................................ ....................... 11 ETF vs Index Funds ................................ ................................ ................................ .......................... 14 ETF vs Closed ended Funds................................ ................................ ................................ .............. 17 Indian ETF Market ................................ ................................ ................................ ........................... 19 Opportunities in Indian Market ................................ ................................ ................................ ...... 21

1.

What is an ETF?

A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold. Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated every day like a mutual fund does. By owning an ETF, you get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order. One of the most widely known ETFs is called the Spider (SPDR), which tracks the S&P 500 index and trades under the symbol SPY. As the name suggests, ETFs are a mix of a stock and a MF in the sense that y Like mutual funds they comprise a set of specified stocks e.g. an index like Nifty/Sensex or a commodity e.g. gold; and y Like equity shares they are traded on the stock exchange on real -time basis. How does an ETF work? In a normal fund we buy/sell units directly from/to the AMC. First th e money is collected from the investors to form the corpus. The fund manager then uses this corpus to build and manage the appropriate portfolio. When you want to redeem your units, a part of the portfolio is sold and you get paid for your units. The units in a conventional MF are, therefore, called in-cash units. But in ETF, we have something called the authorized participants (appointed by the AMC). They will first deposit all the shares that comprise the index (or the gold in case of Gold ETF) with the AMC and receive what is called the creation units from the AMC. Since these units are created by depositing underlying shares/gold, they are called in -kind units. These creation units are a large block, which are then split into small units and ac cordingly bought/sold in the open market on the stock exchange by these authorized participants . Therefore, technically every buy and sell need not change the corpus of an ETF unlike a conventional MF. However, as and when there is more demand, these authorized participants deposit more shares with the AMC and get more creation units to satisfy the demand. Or if there is more redemption, then they give back these creation units to the AMC, take back their shares, sell them in the market and pay the inv estor.

All this may seem to be a bit complicated and time -consuming. But, in effect, it is all system driven and hence happens on real -time basis with minimal effort & cost. Advantages of investing in ETFs y Convenient to trade as it can be bought/sold on the stock exchange at any time of the day when the market is open (index funds can be bought only at NAV based on closing prices) y One can short sell an ETF or buy on margin or even purchase one unit, which is not possible with index-funds/conventional MFs y ETFs are passively managed, have low distribution costs and minimal administrative charges. Hence most ETFs have lower expense ratios than conventional MFs y Not dependent on the fund manager y Like an index fund, they are very transparent Disadvantages of investing in ETFs y SIP in ETF is not convenient as you have to place a fresh order every month y Also SIP may prove expensive as compared to a no-load, low-expense index funds as you have to pay brokerage every time you buy & sell y Because ETFs are conveniently tradable, people tend to trade more in ETFs as compared to conventional funds. This unnecessarily pushes up the costs. y You can t automatically re-invest your dividends. Secondly, you may have to pay brokerage to reinvest dividends in ETF, whereas dividend reinvestment in MFs is automatic and with no entry-load y Comparatively lower liquidity as the market has still not caught up on the concept It may, therefore, be concluded that if an investor is looking for a long -term and defensive investment strategy in equities by backing the index rather than looking at active management, ETF offers an alternative to index-based funds. It offers trading convenience & probably lower costs than index funds. A case -to-case comparison is, however, important as some index-funds may be cheaper. Also for SIPs, index -funds may prove better than ETFs. However, in the absence of conventional MFs like in Gold, ETFs is but a natural and better choice than buying/selling physical gold.

Passive Management - Harness the Market The purpose of an ETF is to match a particular market index, leading to a fund management style known as passive management. Passive management is the chief distinguishing feature of ETFs, and it brings a number of advantages for investors in index funds. Essentially, passive management means the fund manager makes only minor, periodic adjustments to keep the fund in line with its index. This is quite different from an actively managed fund, like most mutual funds, where the manager continually trades asset s in an effort to outperform the market. Because they are tied to a particular index, ETFs tend to cover a
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discrete number of stocks, as opposed to a mutual fund whose scope of investment is subject to continual change. For these reasons, ETFs mitigate the element of "managerial risk" that can make choosing the right fund difficult. Rather than investing in a fund manager, when you buy shares of an ETF you're harnessing the power of the market itself. Cost-efficient and Tax-efficient Because an ETF tracks an index without trying to outperform it, it incurs fewer administrative costs than actively managed portfolios. Typical ETF administrative costs are lower than an actively managed fund, coming in less than .20% per annum, as opposed to the over 1% yearly cost of some mutual funds. Because they incur low management and sponsor fees, and because they don't typically carry high sales loads, there are fewer recurring costs to diminish your returns. Passive management is also an advantage in terms of tax efficiency. ETFs are less likely than actively managed portfolios to experience the trading of securities, which can create potentially high capital gains distributions. Fewer trades into and out of the trust mean fewer taxable distributions, and a more efficient overall return on investment. Efficiency is one reason ETFs have become a favored vehicle for multiple investment strategies - because lower administrative costs and lower capital gains taxes put a greater share of your investment dollar to work for you in the market. Flexibility ETF shares trade exactly like stocks. Unlike index mutual funds, which are priced only after market closings, ETFs are priced and traded continuously throughout the trading day. They can be bought on margin, sold s hort, or held for the long -term, exactly like common stock. Yet because their value is based on an underlying index, ETFs enjoy the additional benefits of broader diversification than shares in single companies, as well as what many investors perceive as the greater flexibility that goes with investing in entire markets, sectors, regions, or asset types. Because they represent baskets of stocks, ETFs, or at least the ones based on major indexes, typically trade at much higher volumes than individual stocks. High trading volumes mean high liquidity, enabling investors to get into and out of investment positions with minimum risk and expense. Long-Term Growth It was in the late 1970s that investors and market watchers noticed a trend involving market indexes - the major indexes were consistently outperforming actively managed portfolio funds. In essence, according to these figures, market indexes make better investments than managed funds, and a buy-and-hold strategy is the best strategy to reap the advantages of investing in index growth.

2.

TYPES OF ETFs

Index ETFs Most ETFs are index funds that hold securities and attempt to replicate the performance of a stock market index. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index. Some index ETFs, known as leveraged ETFs or inverse ETFs, use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the daily performance of the index. As of February 2008, index ETFs in the United States included 415 domestic equity ET Fs, with assets of $350 billion; 160 global/international equity ETFs, with assets of $169 billion; and 53 bond ETFs, with assets of $40 billion. As of November 2010 an index ETF, namely Standard & Poor's Depositary Receipts (SPDR S&P 500), was the largest ETF by market capitalization. Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called "replication". Other index ETFs use "representative sampling", investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, such as fu tures, option and swap contracts, and securities not in the underlying index, that the fund's adviser believes will help the ETF to achieve its investment objective. For index ETFs that invest in indexes with thousands of underlying securities, some index ETFs employ "aggressive sampling" and invest in only a tiny percentage of the underlying securities.

Commodity ETFs or ETCs Commodity ETFs invest in commodities, such as precious metals and futures. Among the first commodity ETFs were gold exchange-traded funds, which have been offered in a number of countries. The idea of a Gold ETF was first officially conceptualised by Benchmark Asset Management Company Private Ltd in India when they filed a proposal with the SEBI in May 2002. The first gold exchange-traded fund was Gold Bullion Securities launched on the ASX in 2003, and the first silver exchange-traded fund was iShares Silver Trust launched on the NYSE in 2006. As of November 2010 a commodity ETF, namely SPDR Gold Shares, was the second-largest ETF by market capitalization. However, generally commodity ETFs are index funds tracking non-security indexes. Because they do not invest in securities, commodity ETFs are not regulated as investme nt companies under the Investment Company Act of 1940 in the United States, although their public offering is subject to SEC review and they need an SEC no-action letter under the Securities Exchange Act of 1934. They may, however, be subject to regulation by the Commodity Futures Trading Commission.

Exchange-traded commodities (ETCs) are investment vehicles (asset backed bonds, fully collateralised) that track the performance of an underlying commodity index including total return indices based on a single commodity. Similar to ETFs and traded and settled exactly like normal shares on their own dedicated segment, ETCs have market maker support with guaranteed liquidity, enabling investors to gain exposure to commodities, on -Exchange, during market hours. The earliest commodity ETFs (e.g., GLD and SLV) actually owned the physical commodity (e.g., gold and silver bars). Similar to these are NYSE: PALL (palladium) and NYSE: PPLT (platinum). However, most ETCs implement a futures trading strategy, which may produce quite different results from owning the commodity. Commodity ETFs trade just like shares, are simple and efficient and provide exposure to an ever-increasing range of commodities and commodity indices, including energy, metals, softs and agriculture. However, it is important for an investor to realize that there are often other factors that affect the price of a commodity ETF that might not be immediately apparent. For example, buyers of an oil ETF such as USO might think that as long as oil goes up, they will profit roughly linearly. What isn't clear to the novice investor is the method by which these funds gain exposure to their underlying commodities. In the case of many commodity funds, they simply roll so -called front-month futures contracts from month to month. This does give exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll.

Bond ETFs Exchange-traded funds that invest in bonds are known as bond ETFs. They thrive during economic recessions because investors pull their money out of the stock market and into bonds (for example, government treasury bonds or those issues by companies regarded as financially stable). Because of this cause and effect relationship, the performance of bond ETFs may be indicative of broader economic conditions. There are several advantages to bond ETFs such as the reasonable trading commissions, but this benefit can be negatively offset by fees if bought and sold through a third party.

Currency ETFs or ETCs In 2005, Rydex Investments launched the first ever currency ETF called the Euro Currency Trust (NYSE: FXE) in New York. Since then Rydex has launched a series of funds tracking all major currencies under their brand CurrencyShares. In 2007 Deutsche Bank's db x-trackers launched EONIA Total Return Index ETF in Frankfurt tracking the euro, and later in 2008 the Sterling Money Market ETF (LSE: XGBP) and US Dollar Money Market ETF (LSE: XUSD) in London. In 2009, ETF Securities launched the world's largest FX platform tracking the MSFXSM Index covering 18 long or short USD ETC vs. single G10 currencies. The funds are
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total return products where the investor gets access to the FX spot change, local institutional interest rates and a collateral yield.

Actively managed ETFs Actively managed ETFs are quite recent in the United States. The first one was offered in March 2008 but was liquidated in October 2008. The actively managed ETFs approved to date are fully transparent, publishing their current securities portfolios on their web sites daily. However, the SEC has indicated that it is willing to consider allowing actively managed ETFs that are not fully transparent in the future. The fully transparent nature of existing ETFs means that an actively managed ETF is at risk from arbitrage activities by market participants who might choose to front run its trades. The initial actively traded equity ETFs have addressed this problem by trading only weekly or monthly. Actively traded debt ETFs, which are less susceptible to front-running, trade their holdings more frequently. The initial actively managed ETFs have received a lukewarm response and have been far less successful at gathering assets than were other novel ETFs. Among the reasons suggested for the initial lack of market interest are the steps required to avoid front -running, the time needed to build performance records, and the failure of ac tively managed ETFs to give investors new ways to make hard-to-place bets.

Exchange-traded grantor trusts An exchange-traded grantor trust share represents a direct interest in a static basket of stocks selected from a particular industry. The leading example is Holding Company Depositary Receipts, or HOLDRs, a proprietary Merrill Lynch product. HOLDRs are neither index funds nor actively managed; rather, the investor has a direct interest in specific underlying stocks. While HOLDRs have some qualities in common with ETFs, including low costs, low turnover, and tax efficiency, many observers consider HOLDRs to be a separate product from ETFs.

Leveraged ETFs Leveraged exchange-traded funds (LETFs), or simply leveraged ETFs, are a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non leveraged ETFs. Leveraged index ETFs are often marketed as bull or bear funds. A leveraged bull ETF fund might for example attempt to achieve daily returns that are 2x or 3x more pronounced than the Dow Jones Industrial Average or the S&P 500. A leveraged inverse (bear) ETF fund on the other hand may attempt to achieve returns that are -2x or -3x the daily index return, meaning that it will gain double or triple the loss of the market.
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Leveraged ETFs require the use of financial engineering techniques, including the use of equity swaps, derivatives and rebalancing to achieve the desired return. The most common way to construct leveraged ETFs is by trading futures contracts. The rebalancing of leveraged ETFs may have considerable costs when markets are volatile. The problem is that the fund manager incurs trading losses because he needs to buy when the index goes up and sell when the index goes down in order to maintain a fixed leverage ratio. A 2.5% daily change in the index will for example reduce value of a -2x bear fund by about 0.18% per day, which means that about a third of the fund may be wasted in trading losses within a year(0.9982^252=0.63). Investors may however circumvent this problem by buying or writing futures directly, accepting a varying leverage rati o.

3.

US ETF MARKET

The combined market value of U.S. exchange-traded funds surpassed $1 trillion f or the first time in 2010, with ETFs investing in emerging markets and bonds receiving the most new money. Total market capitalization surged 30 percent from $782 billion at the end of 2009. A total of $111.4 billion in net new money flowed into the funds last year, including $18.9 billion in December, according to a report today from the Westport, Connecticut -based firm. Emerging-market ETFs took in $32.2 billion in 2010, while bond funds had net inflows of $23.7 billion. U.S. sector ETFs were in third place at $13.9 billion. Funds that buy U.S. stocks saw a surge in inflows during the past two months, while bond ETFs have experienced outflows for the first time since October 2008 . The Standard & Poor s 500 Index, the benchmark measure of American equities, posted the biggest December advance since 1991 and the largest September -and-October rally in 12 years.

In the US, ETFs are extremely popular investment instruments. Aggregated US ETF turnover exceeds turnover in stocks and is highly concentrated. The av erage daily dollar turnover of the largest five ETFs was $11 billion in 2008 lume represents a growing percentage of all securities trades in the US. US equity focused ETFs dominate an increasingly wider variety of underlying indices.

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4.

ETF VS MUTUAL FUNDS

1. Since all ETFs require certain specific shares to be deposited for units to be created, they all are usually index-specific like Nifty, Sensex, Bankex etc. As against this, a conventional MF can have any portfolio (though as per the pre -defined objective). Of course index funds will also mimic the index and hence to that extent ETFs & index funds are same 2. Because ETFs are index-specific, the portfolio remains more or less constant, whereas portfolio of an actively managed conventional MF will change on day -to-day basis. Hence, while portfolio of ETF is known beforehand, the portfolio of a conventional MF can be known only at the time of month-end disclosures. 3. ETFs are bought/sold on the stock exchange and need a demat account. Conventional MFs are bought/sold from/to the AMC. 4. ETFs can be traded like a stock at any time of the day and at real-time prices, while the market is open. Whereas, one can buy MFs only at the NAV based on the closing prices. 5. The unit capital of close-ended funds (and even shares) will not change with trading. But unit capital of ETF can change with trading and hence to that extent they behave like open ended funds 6. There are some close-ended funds listed on the exchange. But because they are structurally different from an ETF, they can trade at substantial discount (or premium) to the NAV. This will not be the case with ETFs. 7. Like conventional MFs, they offer the benefits of diversification 8. As financial instruments per se, ETFs are as safe as conventional MFs. But, of course, the market risk remains. 9. In ETF, AMCs need not keep a large portion in cash to meet redemption pressures 10. Also, unless there is a huge redemption pressure, shares need not be sold to generate cash to meet the redemptions the normal buying & selling of units amongst the investors will take care of day-to-day redemptions. To that extent, ETFs are somewhat protected 11. In ETF each investor pays his share of costs, unlike conventional MFs where costs are deducted from the NAV on an average basis. As such the long -term investors suffer, while short-term investors end-up paying lesser costs in conventional MFs.

Factors to be considered when comparing ETFs with mutual funds Costs Because ETFs trade on an exchange, each transaction is generally subject to a brokerage commission. Commissions depend on the brokerage and which plan is chosen by the customer. For example, a typical flat fee schedule from an online brokerage firm in the United States range from $10 to $20, but can be as low as $0 with discount brokers. Due to this commission cost, the amount invested has a great bearing; someone who wishes to invest $100 per month may have a significant percentage of their investment dest royed immediately, while for someone making a $200,000 investment, the commission cost may
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be negligible. Generally, mutual funds obtained directly from the fund company itself do not charge a brokerage fee. Thus when low or no-cost transactions are available, ETFs become very competitive. ETFs have a lower expense ratio than comparable mutual funds. Not only does an ETF have lower shareholder-related expenses, but because it does not have to invest cash contributions or fund cash redemptions, an ETF does not have to maintain a cash reserve for redemptions and saves on brokerage expenses. Mutual funds can charge 1% to 3%, or more; index fund expense ratios are generally lower, while ETFs are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference. The cost difference is more evident when compared with mutual funds that charge a front end or back-end load as ETFs do not have loads at all. The redemption fee and short -term trading fees are examples of other fees associated with mutual funds that do not exist with ETFs. Traders should be cautious if they plan to trade inverse and leveraged ETFs for short periods of time. Close attention should be paid to transaction costs and daily performance rates as the potential combined compound loss can sometimes go unrecognized and offset potential gains over a longer period of time.

Taxation ETFs are structured for tax efficiency and can be more attractive than mutual funds. In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must distribute the capital gains to its shareholders. This can happen whenever the mutual fund sells portfolio securities, whether to reallocate its investments or to fund shareholder redemptions. These gains are taxable to all shareholders, ev en those who reinvest the gains distributions in more shares of the fund. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF shares on the stock market, as they would a stock, or effect a non -taxable redemption of a creation unit for portfolio securities), so that investors generally only realize capital gains when they sell their own shares or when the ETF trades to reflect changes in the underlying index. In most cases, ETFs are more tax-efficient than conventional mutu al funds in the same asset classes or categories. Because Vanguard's ETFs are a share-class of their mutual funds, they don't get all the tax advantages if there are net redemptions on the mutual fund shares. Although they do not get all the tax advantages, they get an additional advantage from tax loss harvesting any capital losses from net redemptions. In the U.K., ETFs can be shielded from capital gains tax by placing them in an Individual Savings Account or self-invested personal pension, in the same manner as many other shares.

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Trading Perhaps the most important benefit of an ETF is the stock-like features offered. Since ETFs trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement). Also, many ETFs have the capability for options (puts and calls) to be written against them. Covered call strategies allow investors and traders to potentially increase their returns on their ETF purchases by collecting premiums (the proceeds of a call sale or write) on calls written against them. Mutual funds do not offer those features.

Some other benefits: 1. Tax Benefits The biggest advantage an ETF has over a mutual fund is the tax benefit. Due to their construction, ETFs only incur capital gains taxes when the fund is sold. In a mutual fund, capital gain taxes are incurred as the shares within the fund are traded during the life of the investment. 2. Simplicity When you buy or sell an ETF, it is done at one price with one transaction. You are a trade away from opening or closing a position. With mutual funds, shares in the asset are constantly being traded to hit a target price and seek a desired performance. Multiple trades, multiple prices. 5. Transferability Whenever a managed portfolio is switched to a different investment firm, complications arise with mutual funds. Sometimes the fund positions have to be closed out before a transfer can take place. That can be a major headache for investors. Liquidating a portfolio s mutual funds may increase risk, increase commissions and fees, and incur early capital gains taxes. With an ETF, the transfer is clean and simple when switching investment firms. They are considered a portable investment.

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5.

ETF VS INDEX FUNDS

Exchange Traded Funds (ETFs) have recently become somewhat popular. At their heart, they are basically just index mutual funds which are bought and sold as stocks. In that way, they are similar to closed-end mutual funds which happen to be index funds. However, they have several interesting features which make them more similar to conventional (open -end) index mutual funds. A list of ETF pros and cons as compared to conventional index mutual funds. ETF PROS y Some ETFs may have lower expense ratios than similar conventional index mutual funds. If true, this suggests that ongoing management fees would be lower, which favors ETFs. However, note that most ETFs have expense ratios which are not dramatically lower than the lowest cost conventional index mutual funds with similar investment goals. y ETFs may be somewhat more tax efficient than similar conventional index mutual funds. This increased tax-efficiency is in the form of lower capital gains distributions (which effectively means that an ETF's capital gains tend to be more deferred than a similar mutual fund's would be). The idea that ETFs should have lower capital gains distributions comes from their ability to shed their lowest-basis shares to institutional arbitrageurs through in kind redemptions. Note that this benefit applies to a much lesser extent to V anguard's ETFs. Because they exist as a separate share class of conventional mutual funds, any tax benefit a Vanguard ETF generates is shared by investors in the fund's non -ETF shares, thus diluting the beneficial effect for Vanguard ETF share owners. y ETFs may have somewhat less "cash drag" than similar conventional mutual funds. Conventional mutual funds typically need to maintain a small amount of their portfolio in cash in order to meet ongoing cash redemptions. An ETF has no such need because it never has to deal with the possibility of cash redemptions. This may provide a slight advantage for ETFs over similar index mutual funds. ETF CONS y When you buy or sell an ETF, you implicitly pay (as a "hidden" fee) one -half of the ETF's "bid-ask spread." Bid-ask spread is the difference in price between the market price for buying the ETF and the market price for selling the ETF. Note that, for a conventional no load mutual fund, there is no bid -ask spread involved. An ETF's bid-ask spread can be quite small (e.g., for domestic large-cap stock ETFs and Treasury Bond ETFs) or quite large (e.g., for certain country-specific emerging market ETFs). In our opinion, this may be the biggest "con" to consider for ETFs. Bid-ask spreads make it impractical to hold ETFs for very short lengths of time (i.e., because it probably doesn't make sense to incur this implicit purchase/redemption fee very often).
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However, even if an ETF has a large bid-ask spread, it is conceptually possible for it to outperform a similar conventional index mutual fund in the long run if (and only if) both of the following are true:  The ETF has a lower expense ratio than the similar conventional index mutual fund.  The ETF will be held long enough for the compounded benefit of the lower expe nse ratio to exceed the higher costs of the bid -ask spread. y In order to buy or sell an ETF, you need to pay a brokerage commission. If you buy/sell through a discount broker, this might be on order of $10/trade (no such fees are typically needed to buy/sell a no-load mutual fund). This fact makes dollar-cost averaging small amounts into ETFs impractical. ETFs are most practical for deploying relatively large amounts of capital. y ETFs may not be as tax efficient as you'd like. At present, qualifying dividend distributions from stocks are taxed at a preferentially low tax rate in the United States. One of the requirements to qualify for this low rate is that the stock has been held for at least 60 days. Due to share creation activity, this standard may not be met all the time. Thus, a portion of the dividend income received (and distributed) by the ETF may not qualify for the preferentially low tax rate for qualifying dividends. Conventional index mutual funds have more control over this than do ETFs, and are therefore more likely to have a higher percentage of their distributed dividends qualify for the preferentially low tax rate. y ETFs won't track indexes as well as conventional index mutual funds. A mutual fund's share price is always, by definition, the fund's net asset value (NAV). The NAV is just the weighted-average current market value of all the fund's holdings, expressed on a per -share basis. An ETF, on the other hand, is valued by the market. So even if its holdings are EXACTLY consistent with those of the index, its market price at any particular time can be either above or below the NAV (meaning it can be sold at either a higher or lower price than the per-share value of its underlying securities). The difference between NAV and market price for an ETF won't ever be very high because institutional arbitrageurs are able to either create or redeem shares of the ETF using the underlying stocks. This tends to drive the ETF price back towards its NAV. However, this tracking error is likely to be higher for ETFs which hold less liquid securities (e.g., emerging markets stocks). y ETFs have poor coverage of foreign style/size indexes. If you wanted to buy a foreign value ETF, for example, there are very few options at present. There is a much greater selection of non -ETF foreign mutual funds covering the gamut of style and size combinations. y There are few bond ETF options available at present. However, note that ETFs are less desirable for bonds anyway since a relatively small portion of a bond's total return is due to capital gains, the tax efficiency benefit of bond ETFs is relatively trivial. y If the ETF is organized as a Unit Investment Trust (e.g., the original SPDR ETF), then all dividends the fund receives are required to be held in a non -interest bearing account until
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distributed to investors. This causes a "cash-drag" on the fund's earnings which conventional index mutual funds (and non -UIT ETFs) don't experience. y Most people choose to have distributions of conventional mutual funds automat ically reinvested in additional shares of the fund. This is convenient it keeps your money working for you without requiring extra effort on your part to redeploy the distributions. On the other hand, ETFs don't have this as an alternative. They pay out distributions as cash. If you want to then reinvest that cash, you need to take some action to do so (and incur whatever transaction costs apply). y Apparently, you can only buy/sell ETFs in whole share lots. In other words, while you can buy exactly $5,849.23 of some mutual fund, you can't necessarily buy that much in an ETF you have to buy whole shares (not fractional shares). This isn't a big deal, you just have a bit less flexibility and there may be a little more "cash -drag" in your account if you use ETFs instead of mutual funds. But then again, ETFs tend to hold lesser amounts of cash themselves (since they don't have to keep cash on hand to meet cash redemptions, as do mutual funds).

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6.

ETF VS CLOSED ENDED FUNDS

It's important for investors to understand the key differences between closed -end funds (CEFs) and exchange-traded funds (ETFs). Each has its advantages and disadvantages. This knowledge can translate into making informed investment decisions. Focusing on the key points: Fees The expense ratios of ETFs are generally lower versus CEFs. Since ETFs are indexed portfolios, the cost of managing them is less compared to actively managed portfolios. Also, ETFs often have lower internal trading costs versus actively managed funds, due to their low portfolio turnover. The ETF cost savings can be significant, especially for long -term investors. Investing in both ETFs and CEFs will usually result in brokerage commissions. Information on specific fees, charges, and exp enses is obtained in the fund prospectus. Fund Transparency and NAV Because fund components are pegged to an index, the transparency of ETF holdings is excellent. Investors can easily identify the underlying stocks, bonds, or commodities of a fund by consulting the index provider or fund sponsor. CEFs have less transparency because their portfolios are actively managed, but holdings can be uncovered by viewing quarterly or semiannually fund disclosures. ETFs generally trade close to their net asset value (NAV). It s rare to see ETFs trading at a large premium or discount to their NAV, but it can happen. Historically, institutions have seen this as an arbitrage opportunity by creating or liquidating creation units. This process keeps ETF share prices closely hinged to the NAV of the underlying index or basket of securities. By contrast, CEFs are more likely to trade at a premium or discount to their NAV. The premium is usually a result of greater demand (more buyers than sellers) for a fund s shares, whereas a discount would imply less demand (more sellers than buyers). The NAV is calculated by subtracting a fund s liabilities from its total assets and dividing the figure by the number of shares outstanding. Style Drift and Leverage Active CEFs are more susceptible to style drift versus index ETFs. Style drift is common with actively managed portfolios as money managers will sometimes divert from their original investment strategy. On the other hand, ETFs are generally insulated from style drift because a portfolio manager's freedom to hand pick securities outside the scope of an index is limited.

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Many CEFs are leveraged, which magnifies the fluctuations of the NAV. If portfolio managers are correct about their selections, leverage is beneficial. At the opposi te spectrum, poor investment decisions in a leveraged portfolio can be damaging. ETFs do not currently use leverage as part of their investment strategy, but this could change in the future. Exchange-Traded Funds YES YES YES YES YES(1)

Closed-End Funds VS. ETFs Continuous trading and pricing throughout the day? Can be bought on margin? Can buy/sell options? Sold by prospectus? Can use in an IRA, 401(k), or another retirement plan?

Closed-End Funds

YES YES NO YES YES(1)

Can be purchased through a traditional or YES online broker? Minimum investment or share amount required? Traded on what exchanges? NO Amex, NYSE Arca, NASDAQ

YES

NO(2) Amex, NYSE Arca, NASDAQ

Taxes and Portfolio Turnover Annually, both ETFs and CEFs are required to distribute dividends and capital gains to shareholders. This is usually done at the end of each year and these distributions can be caused by index rebalancing, diversification rules, or other factors. Also, anytime you sell your fund this could generate tax consequences. ETFs are renowned for having low portfolio turnover, which is good for investors, because it reduces the possibility of tax gain distributions. By comparison, actively managed portfolios generally have higher turnover, which translates int o more frequent tax distributions.

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7.

INDIAN ETF MARKET

Exchange Traded Funds or ETFs have revolutionized the Investment Industry in recent times due to their simplicity, low costs and ease of use. The US Market has seen a massive growth in the usage of this Financial Instrument with a mind boggling variety of ETFs catering to almost every asset class ranging from equities, bonds, currencies, commodities and even derivatives. The low cost of the ETFs compared to the mutual funds and their passive form has attracted investors in huge droves. These instruments have a very low percentage cost ranging in the 0.5% range compared to 2% or more for mutual funds. Also unlike MFs, these can be traded like a normal stock during market hours compared to Mutual Fund s which can only be traded after the close of the markets. There is a massive amount of literature available on the ETFs so I won t write more on that here. Indian ETF evolution The Indian Market despite being classified as an Emerging Market has seen con tinuous reforms by the stock market regulator SEBI making the Indian market a pathbreaker in some respects. This institution has been very proactive in deepening and reforming the stock markets in India. Though hazards for Indian investors are present, the market regulator has been trying to curb them through new rules .ETFs in India have been around for a while, but have not won become popular in a substantial way. Benchmark Asset Managment Company (AMC) has been the only AMC which has focused on the ETF sector in India. The expenses of ETFs launched by this company are decently low and are passively managed (unlike some others). What has helped is that Benchmark AMC does not have a huge Mutual Fund portfolio to market like other AMCs. Mutual Funds are much more profitable for an AMC and it does not make sense for them to actively pursue the less profitable ETFs. India also does not have large independent Buy-Side Funds which would increase demand for ETFs. Benchmark AMC despite having the largest variety o f ETFs has managed to get some measure of success with only two of its ETFs. The first one is Nifty Bees based on India s NIFTY 50 stock index and the second is LIQUIDBEES which has been marketed as the world s first money market based ETF. The other ETFs launched by this company have suffered from low volumes and not garnered much success. It also recently launched India s first foreign ETF HNGSNGBEES based on the Hong Kong s Hang Seng Stock Index. This ETF too does not seem to be getting much success. Other Fund Houses Almost Non -Existent in ETF Products India s large AMCs like Reliance, Kotak, Prudential, HSBC, HDFC etc have been laggards in the ETF segment. While most of the fund houses have started ETFs based on Gold and Stock Indices, they remain quite unpopular till now. It is not a big surprise considering their relatively high expenses, lack of differentiation and non -passive nature. The whole purpose of an ETF is defeated if its expense structure is too high or its passive nature of investing is violated. ETFs in India is certain to grow in the future due tits excellent value proposition
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compared to other financial instruments like Mutual Funds. The current state of the ETF sector reveals it to be severely underpenetrated lacking both in depth and variety. Benchmark is the only AMC be focusing on this sector. There is an excellent opportunity for a new player to make a mark in this sector considering its huge growth potential.

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8.

OPPORTUNITIES IN INDIAN MARKET

Exchange Traded Funds (ETFs) have been in existence in India for quite some time now. But so far ETFs have not enjoyed the kind of popularity that the conventional Mutual Funds enjoy. One reason could be the lack of understanding of the concept of ETF amongst the general investor. Second, and probably the more important reason, is that ETFs by nature track a certain index (e.g. Nifty or the Bankex). Hence, the returns one can expect from ETFs will be equal to the rise in the index. Whereas, India is a growing market and hence offers huge opportunities in the non -index shares too. Therefore, it is not difficult for an active fund manager to beat the index and offer better returns. As such ETFs (and index -funds too, by that logic) have comparatively negligible AUMs. Two things could, however, make ETFs popular in India y One, of course, is that as market valuations become fairly or over -valued, it will become more & more difficult to beat the index. Then index -based funds (both conventional MFs & ETFs) may become a better option than actively-managed funds y Gold ETFs or Real-Estate ETFs have no comparable product in the conventional MF sector, and hence become the only MF route to invest in such markets Here s an interesting live example. About 1-2 years ago the banking sector was not very popular. But with the rise in interest rates and the general economic growth, bank stocks were becoming quite popular. As a result the only banking index fund viz. Benchmark AMC s the Banking BeES (there are few banking sector funds but not bank -index funds) saw a jump of AUM from about Rs.370 crores in June 2005 to almost Rs.7,400 crores by December 2006. This makes it the largest MF scheme, much higher than about Rs.5000 crores Reliance Equity Fund.

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