ETFs have advantages over other fund types

Exchange Traded funds (ETFs) are a major class of mutual funds. Though not as popular among retail investors, they have numerous advantages over the straitjacket mutual fund.

The genesis of this category dates back to 1989 when the first index type ETF was traded on the American Stock Exchange.

The distinguishing factor that these funds have vis-à-vis ordinary mutual funds is the manner of purchases and redemptions. This is because the units of these funds are listed on the stock exchange just like the stocks of a company. An ETF can be bought or sold over the exchange through a broker on a daily basis during trading hours. (See box for differences)

In India, ETFs where first launched by Benchmark Asset Management Company, which launched the Nifty Benchmark Exchange Traded Scheme (Nifty BeES) based on S&P CNX Nifty Index.

In the domestic market, ETFs have not yet captured investors’ favour, which is in stark contrast to more developed markets.

While the most common type of ETFs are very similar to an index fund, there are ETFs of a non-index kind, too.

A case in point is the gold ETF, which is a commodity based ETF. Commodity based ETFs are also traded on the stock exchange; however, the underlying holdings of the units are physical commodities.

The most common ETFs in India track an index. These ETFs do not stick to the basic Sensex and Nifty as is the case with most index funds, but offer more options to the investor. The most recent addition is the Shariah-based ETF launched by Benchmark Asset Management Company, which intends tracking the Nifty Shariah Index. Other than this, there are ETFs which track only PSU banks and invest in money market instruments.

Trading volumes
In India, we have had little success with closed-ended schemes being traded on the stock exchange.

Historically, there has been a considerable arbitrage between the net asset value (NAV) and traded price of listed closed-ended mutual funds. This arbitrage arises because the unit price is affected by demand and supply pressures in addition to the movement in the value of the underlying instrument. Such arbitrageurs are always in the market to take advantage of any significant premium or discount between the ETF market price and its NAV. Hence, if the trading volumes are robust, the NAV and market price will converge and arbitrage will disappear.

We looked at a couple of ETFs to assess the difference between the NAV and traded price. In case of larger ETFs, there is only a very small arbitrage opportunity available. However, in case of the smaller ETFs, the arbitrage can go up to Rs 34 per unit.

Moreover, smaller ETFs not only have less liquidity but at times are not traded at all. Hence, investors need to be a little cautious while picking an ETF.

We have collated the information on trading volumes to give you a better picture of what kind of trading happens in these ETFs. To put things in perspective, the average trading volume of Reliance Industries — one of the most traded stocks — was Rs 812 crore in the year to March 13, 2009.

Tracking error
In a perfect market, ETF investors would get exactly what they invest into. If the underlying index was up 100% for the year, an investment of Rs 100 would become Rs 200. But that, unfortunately, is rarely the situation.

Index portfolios, no matter how well run, always suffer from some amount of “tracking error.”

Tracking error is the difference between the returns of a fund and the returns of its underlying benchmark. Generally speaking, the less of it, the better.

We looked at the tracking error of the index-based ETFs and didn’t find anything out of the ordinary. There is nothing drastically different between these ETFs and they are closely positioned.

The expense ratio charged by ETFs is also lower than those charged by index funds. Presently, the ETF category has an expense ratio of 0.73%, whereas the expense ratio of index fund category stood at 1.36%, reflecting a significant difference in the expenses.

Performance
In terms of performance, equity ETFs compare on an equal footing with index funds, given that they track similar indices.

The banking sector ETFs have not performed as well as the large-cap ETFs tracking the Nifty and the Sensex.

The only small-cap ETF has also performed poorly on account of the meltdown in smaller cap stocks.

The gold ETFs have of course performed exceedingly well owing to the rally in gold prices.

The Liquid BeEs has delivered consistent performance. However, when compared with the average open-ended liquid fund, the returns don’t look very impressive. The average open-ended liquid fund delivered 8% returns over the one year period ending March 12, 2009. Even over the longer timeframes of three and five years, the open-ended liquid schemes have put up a better performance.

At the end of the day, what makes ETFs an attractive proposition is the convenience they offer.

ICRA Online Research Desk