INTRODUCTION TO EXCHANGE TRADED FUNDS
Exchange Traded Funds (ETFs) are mutual fund units which investors buy/ sell from the stock exchange, as against a normal mutual fund unit, where the investor buys / sells through a distributor or directly from the AMC. ETF as a concept is relatively new in India. It was only in early nineties that the concept gained in popularity in the USA. ETFs have relatively lesser costs as compared to a mutual fund scheme. This is largely due to the structure of ETFs. While in case of a mutual fund scheme, the AMC deals directly with the investors or distributors, the ETF structure is such that the AMC does not have to deal directly with investors or distributors. It instead issues units to a few designated large participants, who are also called as Authorized Participants (APs), who in turn act as market makers for the ETFs. The Authorized Participants provide two-way quotes for the ETFs on the stock
exchange, which enables investors to buy and sell the ETFs at any given point of time when the stock markets are open for trading. ETFs therefore trade like stocks. Buying and selling ETFs is similar to buying and selling shares on the stock exchange. Prices are available on real time and the ETFs can be purchased through a stock exchange broker just like one would buy / sell shares. There are huge reductions in marketing expenses and commissions as the Authorized Participants are not paid by the AMC, but they get their income by offering two-way quotes on the floor of the exchange.
Due to these lower expenses, the Tracking Error for an ETF is usually low. Tracking Error is the acid test for an index fund/ ETF. By design an index fund/ index ETF should only replicate the index return. The difference between the returns generated by the scheme/ ETF and those generated by the index is the tracking error.
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Assets in ETFs
Practically any asset class can be used to create ETFs. Globally there are ETFs on Silver, Gold, Indices (SPDRs, Cubes, etc), etc. In India, we have ETFs on Gold, Indices such asNifty, Bank Nifty etc.).
Index ETF
An index ETF is one where the underlying is an index, say Nifty. The APs deliver the shares comprising the Nifty, in the same proportion as they are in the Nifty, to the AMC and create ETF units in bulk (These are known as Creation Units). Once the APs get these units, they provide liquidity to these units by offering to buy and sell through the stock exchange. They give two-way quotes, buy and sell quote for investors to buy and sell the ETFs. ETFs
therefore, have to be listed on stock exchanges. There are many ETFs presently listed on the NSE.
SALIENT FEATURES
An Exchange Traded Fund (ETF) is essentially a scheme where the investor has to buy/ sell units from the market through a broker (just as he/ he would by a share). An investor must have a demat account for buying ETFs (For understanding what is demat please refer to NCFM module ‘Financial Markets: A Beginners’ Module). An important feature of ETFs is the huge reduction in costs. While a typical Index fund would have expenses in the range of 1.5% of Net Assets, an ETF might have expenses around 0.75%. In fact, in international markets these expenses are even lower. In India too this may be the trend once more Index Funds and ETFs come to the market and their popularity increases. Expenses, especially in the long term, determine to a large extent, how much money the investor makes. This is because lesser expenses mean more of the investor’s money is getting invested today and
over a longer period of time, the power of compounding will turn this saving into a significant contributor to the investors’ returns.
If an investor invests Rs 10,000 in 2 schemes each, for 25 years, with both the schemes delivering returns at a CAGR of 12% and the only difference being in the expenses of the schemes, then at the end of the term, while scheme A would have turned the investment into Rs 1.16 Lakhs, scheme B would have grown to Rs 1.40 Lakhs – a difference of Rs 24,327.77! Post expenses, scheme A’s CAGR comes out to be 10.32%, while scheme B’s
CAGR stands at 11.16%.
Gold ETFs (G-ETFs) are a special type of ETF which invests in Gold and Gold related securities. This product gives the investor an option to diversify his investments into a different asset class, other than equity and debt. Traditionally, Indians are known to be big buyers of Gold; an age old tradition. G-ETFs can be said to be a new age product, designed to suit our traditional requirements. We buy Gold, among other things for children’s marriages, for gifting during ceremonies etc. Holding physical Gold can have its’ disadvantages:
1. Fear of theft
2. Payment Wealth Tax
3. No surety of quality
4. Changes in fashion and trends
5. Locker costs
6. Lesser realisation on remoulding of ornaments
G-ETFs score over all these disadvantages, while at the same time retaining the inherent advantages of Gold investing.
In case of Gold ETFs, investors buy Units, which are backed by Gold. Thus, every time an investor buys 1 unit of G-ETFs, it is similar to an equivalent quantity of Gold being earmarked for him somewhere. Thus his units are ‘as good as Gold’.
Say for example 1 G-ETF = 1 gm of 99.5% pure Gold, then buying 1 G-ETF unit every month for 20 years would have given the investor a holding of 240gm of Gold, by the time his child’s marriage approaches (240 gm = 1 gm/ month * 12 months * 20 Years). After 20 years the investor can convert the G-ETFs into 240 gm of physical gold by approaching the mutual fund or sell the G-ETFs in the market at the current price and buy 240 gm of gold.
Secondly, all these years, the investor need not worry about theft, locker charges, quality of Gold or changes in fashion as he would be holding Gold in paper form. As and when the investor needs the Gold, he may sell the Units in the market and realise an amount equivalent to his holdings at the then prevailing rate of Gold ETF. This money can be used to buy physical gold and make ornaments as per the prevailing trends. The investor may also simply transfer the units to his child’s demat account as well! Lastly, the investor will not have to pay any wealth tax on his holdings. There may be other taxes, expenses to be borne from time to time, which the investor needs to bear in mind while buying / selling G-ETFs.
Concept Clarifier – Buying/ Selling ETFs
An investor can approach a trading member of NSE and enter into an agreement with the trading member. Buying and selling ETFs requires the investor to have demat and trading accounts. The procedure is exactly similar to buying and selling shares. The investor needs to have sufficient money in the trading account. Once this is done, the investor needs to tell the broker precisely how many units he wants to buy/ sell and at what price. Investors should take care that they place the order completely. They should not tell the broker to buy/ sell according to the broker’s judgement. Investors should also not keep signed delivery instruction slips with the broker as there may be a possibility of their misuse. Placing signed delivery instruction slips with the broker is similar to giving blank signed cheques to
someone.
WORKING
The G-ETF is designed as an open-ended scheme. Investors can buy/ sell units any time at then prevailing market price. This is an important point of differentiation of ETFs from similar open-ended funds. In case of open-ended funds, investors get units (or the units are redeemed) at a price based upon that day’s NAV. In case of ETFs, investors can buy (or sell) units at a price which is prevailing at that point of time during market hours. Thus, for all
investors of open-ended schemes, on any given day their buying (or redemption) price will be same, whereas for ETF investors, the prices will vary for each, depending upon when they bought (or sold) units on that day.
The way Gold ETFs work is as under:
During New Fund Offer (NFO)
AMC decides of launching G-ETF
Investors give money to AMC and AMC gives units to investors in return
AMC buys Gold of specified quality at the prevailing rates from investors’ money
On an ongoing basis
Authorized Participants (typically large institutional investors) give money/ Gold to AMC
AMC gives equivalent number of units bundled together to these authorized participants (AP)
APs split these bundled units into individual units and offer for sale in the secondary market
Investors can buy G-ETF units from the secondary markets either from the quantity being sold by the APs or by other retail investors
Retail investors can also sell their units in the market
The Gold which the AP deposits for buying the bundled ETF units is known as ‘Portfolio Deposit’. This Portfolio Deposit has to be deposited with the Custodian. A custodian is someone who handles the physical Gold for the AMC. The AMC signs an agreement with the Custodian, where all the terms and conditions are agreed upon. Once the AP deposits Gold with the custodian, it is the responsibility of the custodian to ensure safety of the
Gold, otherwise, he has to bear the liability, to the extent of the market value of the Gold.
The custodian has to keep record of all the Gold that has been deposited/ withdrawn under the G-ETF. An account is maintained for this purpose, which is known as ‘Allocated Account’. The custodian, on a daily basis, enters the inflows and outflows of Gold bars from this account. All details such as the serial number, refiner, fineness etc. are maintained in this account. The transfer of Gold from or into the Allocated Account happens at the end of
each business day. A report is submitted by the custodian, no later than the following business day, to the AMC.
The money which the AP deposits for buying the bundled ETF units is known as ‘Cash Component’. This Cash Component is paid to the AMC. The Cash Component is not mandatory and is paid to adjust for the difference between the applicable NAV and the market value of the Portfolio Deposit. This difference may be due to accrued dividend, management fees, etc. The bundled units (which the AP receives on payment of Portfolio Deposit to the custodian and Cash Component to the AMC) are known as Creation Units.
Each Creation Unit comprises of a pre-defined number of ETFs Units (say 25,000 or 100 or any other number).
Thus, now it can be said that Authorized Participants pay Portfolio Deposit and/ or Cash Component and get Creation Units in return. Each Creation Unit consists of a pre-defined number of G-ETF Units. APs strip these Creation Units (which are nothing but bundled G-ETF units) and sell individual G-ETF units in the market. Thus, retail investors can buy/ sell 1 unit or it’s multiples in the secondary market.
MARKET MAKING BY APS
APs are like market makers and continuously offer two-way quotes (buy and sell). They earn on the difference between the two way quotes they offer. This difference is known as bid-ask spread. They provide liquidity to the ETFs by continuously offering to buy and sell ETF units.
If the last traded price of a G-ETF is Rs. 1000, then an AP will give a two-way quote by offering to buy an ETF unit at Rs 999 and offering to sell an ETF unit Rs. 1001. Thus, whenever the AP buys, he will buy @ 999 and when he sells, he will sell at 1001, thereby earning Rs. 2 as the difference. It should also be understood that the impact of this transaction is that the AP does not increase/ decrease his holding in the ETF. This is known as earning through Dealer Spreads. APs also play an important role of aligning the price of the unit with the NAV. This is done by exploiting the arbitrage opportunities. It should be understood that it is not only APs who can sell ETF units in the market. Retail investors get liquidity by selling their units as well. So, it is not always that the buyer of units is necessarily buying from APs – the seller at the other end may be a retail investor who wishes to exit.
As explained earlier, the custodian maintains record of all the Gold that comes into and goes out of the scheme’s Portfolio Deposit. The custodian makes respective entries in the Allocated Account thus transferring Gold into and out of the scheme at the end of each business day.
The custodian has no right on the Gold in the Allocated Account. The custodian may appoint a sub-custodian to perform some of the duties. The custodian charges fee for the services rendered and has to buy adequate insurance for the Gold held. The premium paid for the insurance is borne by the scheme as a transaction cost and is allowed as an expense under SEBI guidelines. This expense contributes in a small way to the tracking error.
The difference between the returns given by Gold and those delivered by the scheme is known as Tracking Error. It is defined as the variance between the daily returns of the underlying (Gold in this case) and the NAV of the scheme for any given time period.
Gold has to be valued as per a specific formula mandated by regulations. This formula takes into account various inputs like price of Gold in US $/ ounce as decided by the London Bullion Markets Association (LBMA) every morning, the conversion factor for ounce to Kg, the prevailing USD/ INR exchange rate, customs duty, octroi, sales tax, etc.
CREATION UNITS, PORTFOLIO DEPOSIT AND CASH COMPONENT (AN EXAMPLE):
Let us look at the following example to understand Creation Units, Portfolio Deposit and Cash Component in detail. Assumption: 1 ETF unit = 1 gm of 99.5% pure Gold
During New Fund Offer (NFO)
Amount Invested (Rs.): 5000
Price of 1 gm of Gold (Rs.): 1000
Since 1 ETF unit = 1 gm of Gold
Issue Price (Rs.) = 1000
Units Allotted (Number = Investment/ Issue Price): 5
Creation Units
1 Creation Unit = 100 ETF units
NAV (Rs.) = 1050
Price of 1 gm of Gold (Rs.): 1000
So, 100 Units will cost (Rs.) = 1050 * 100 = 1,05,000
100 ETF will be equal to 100 gm of Gold
Therefore, value of Portfolio Deposit (Rs.) = 1000 * 100 = 1,00,000
Hence Cash Component (Rs.) = 1,05,000 – 1,00,000 = 5,000
Thus, it can be seen by depositing Gold worth Rs 1,00,000 as Portfolio Deposit and Rs. 5,000 as Cash Component, the Authorized Participant has created 1 Creation Unit comprising of 100 ETF units.
Let us now see how the Authorized Participant ensures parity between the NAV and market price of the ETFs.
As can be well understood, the price of ETF will be determined by market forces, and although it is linked to the prices of Gold, it will not mirror the exact movements at all given points of time. This will happen due to excess buying or selling pressure on the ETFs, due to which prices may rise or fall more than the Gold price. Such exaggerated movements provide opportunity for arbitrage, which the APs exploit and make risk less gains. This process also ensures that prices of ETF remain largely in sync with those of the underlying.
Consider a case where the demand for ETFs has increased due to any reason. A rise in demand will lead to rise in prices, as many people will rush to buy the units, thereby putting an upward pressure on the prices.
This can be explained by the following example
Price of Gold (Rs. / gm) = 1000
NAV (Rs.) = 1050
CMP of ETF units (Rs.) = 1200
In such a situation an AP will buy Creation Units and sell ETFs in the market.
To purchase 1 Creation Unit, he will have to deposit Gold worth Rs 1,00,000 (Price of Gold * number of ETF units in Creation Units * gm per ETF) as Portfolio Deposit with the custodian and balance Rs. 5,000 as Cash Component with the AMC.
Once he has the Creation Unit, he will sell individual ETF units in the market at Rs. 1200/ unit, thereby making a profit of Rs. 150 (1200 - 1050) per unit.
As he buys physical Gold the price of Gold will increase. Similarly, as he sells fresh ETF units in the market, the supply of ETFs will increase. These two actions will lead to increase in Gold prices and reduction in ETF prices, thereby removing the anomaly in the prices of the ETF units and the underlying.
Similarly, if ETF prices fall way below the price of Gold, APs will buy ETF units cheap and redeem them in Creation Unit lot size. Such an action will reduce supply of ETFs from the market and increase the supply of physical Gold (Gold held with Custodian will come into the market). Both these actions will help align prices of underlying and ETF units as ETF prices will increase due to buying (and subsequent cutting of supply) and price of physical Gold will reduce due to fresh supply in the market.
Corporate actions.
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