Exchange Traded Funds (ETF)

Exchange Traded Funds provide investors with combined benefits of a closed-end and an open-end mutual fund. Exchange Traded Funds follow stock market indices and are traded on stock exchanges like a single stock at index linked prices. The biggest advantage offered by these funds is that they offer diversification, flexibility of holding a single share (tradable at index linked prices) at the same time. Recently introduced in India, these funds are quite popular abroad.

The differences with respect to index funds are :

•           A single NAV is applicable for the day in the case of any open-end funds.   Therefore, a single price would be applicable for all investors who buy units of an open-end index funds on the day.  Similarly, a single price would be recoverable by all investors who wish to exit from an open-end index fund on any day. ETF, on the other hand, is traded in the market place.  Therefore its price keeps changing during the day.  This intra-day fluctuation in ETFs appeals to short-term investors.

•           The ETF’s AMC does not offer sale and repurchase prices for the Units. Instead, it appoints designated market intermediaries (market makers) who buy or sell units from the investors.

Thus, an investor who wants to invest in an ETF would go to a market maker who is expected to offer two-way quotes at all times.  An investor who chooses to invest in the ETF would thus know precisely how many units in the ETF Investor will get against Investor’s investment.

The moneys collected from investors would be invested in index scrips by the market maker.    These investments would become a part of the ETF’s portfolio.

Based on two-way quotes of the market maker, the investor would know how much Investor would recover if Investor were to exit from the ETF.  On exit, the ETF will release index scrips from its portfolio, which the market maker would sell to pay the investor.

The market maker makes money based on the spread in the two-way quote.  Competition between market makers is expected to keep the bid-ask spread low.

•      This structure also ensures that the AMC does not need to pay a commission to market intermediaries for bringing investors into the fund. Similarly, there are no loads recovered by the AMC (the concept of loads is discussed in Chapter 6). Thus, a significant element of cost is eliminated for the investors.  Investors only bear a cost that is implicit in the bid-ask spread.  Low expense ratio is an attraction for any investor.

 •          Returns in an open-end fund can be affected by significant churning of unit holding.  Suppose today many large applications are received in the fund, and tomorrow there are several large redemptions.  The fund manager would be under pressure to buy and sell securities in the market to match such sudden inflows and outflows.  Besides, most open-end funds maintain 5-10% in liquid assets to meet the cash flow requirements for possible redemptions.  These factors can pull down returns in an open-end index fund.

ETFs, as seen earlier, have a different structure where the fund receives (if investor invests) and gives securities (if investor disinvests).  Since such transactions are effected in kind, short-term investments and disinvestments do not affect the performance of the fund.  Long-term investors like this feature in ETFs.