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Exchange Traded Funds Unveiled

Exchange traded funds (ETFs) are in new in India and not very well understood. In an interview with Mutual Fund Insight, Rajan Mehta, Executive Director, Benchmark Mutual Fund, throws light on the benefits of ETFs

Investors think that the main benefit of an ETF is intra-day trading where they can buy and sell the index through the trading session. But the intra-day variation in the NAV of the proposed Gilt BeES and Liquid BeES may not be much compared to that of the Nifty or the Sensex ETFs. What advantage will the investor gain?
Intra-day trading is only one of the many advantages, which ETFs offer. Investors do not know many of the features of ETFs as they are still at a nascent stage internationally as well as in India. Globally, ETFs are growing at rapid speed not only for their intra-day trading capability, but also due to other advantages.

ETFs provide a fair structure where due to the in-kind mechanism for creation and redemption, long-term investors do not subsidise trading costs of short-term investors, which is the case in an open-end structure. The transaction costs, which are the hidden costs and not part of the expense ratio, are minimal in ETF as the subscription or redemption happens in the form of securities directly and no transaction costs are incurred by the fund. Dealing in ETFs is extremely convenient, as it does not require any forms to be filled or cheques/transaction slips to be deposited at service centres. In open-end mutual funds, there are separate account statements for individual funds. As compared to this in ETFs the investor gets a consolidated view through their depository account statement. This reduces paperwork for investors.

ETFs are traded on the National Stock Exchange. The NSE has presence in 400 towns through about 10,000 terminals. Such reach is not economically viable for normal open-end funds. UTI Asset Management (UTI II) has the widest reach among open-end fund companies with a presence in 56 towns. We have already witnessed the power of the NSE network with the Nifty BeES. Investors have already accessed the Nifty BeES from more than 175 towns. We feel that this is a great achievement in a year-and-a-half with negligible ad spend. ETFs have the potential to reach a much wider audience in the retail markets. This is something traditional open-end funds have failed to achieve due to cost-benefit aspects. The intermediary compensation model of ETFs eliminates conflict of interest between the investor and the advisor. In ETFs, the mutual fund do not pay anything to the intermediary but the investor pays directly like it happens when one purchases or sells shares.

In the ETF model, the intermediary is not paid by the fund and, hence, chances are very high that the intermediary would recommend the investment only on merit and suitability and not for any extra incentive paid by the mutual fund.

What benefits can an investor expect by investing in Gilt BeES and Liquid BeES?
Liquid BeES is targeted mainly at active equity market investors. Today, with T+2 settlement in stock markets and three-day cheque clearing time in non-high value segment, cash movement is not very efficient for equity market investors. Liquid BeES will act as an efficient parking vehicle for equity investors. When an investor sells any stock in the market, he can receive Liquid BeES in his demat account and start earning interest from the same day rather than receiving a cheque from the broker, which will get cleared after three days.

Similarly, while buying a stock, an investor can sell Liquid BeES at the same time. Once he transfers the units from his depository account to the broker's account (which requires less than 30 minutes), he does not have any payment obligation. For investors who are willing to invest over Rs 25 lakh, it will also act as a normal open-end mutual fund, where the investor can transact directly with the fund at NAV on T+1 basis. Gilt BeES is targeted to meet totally different investment needs. Today, there is a paucity of long-term fixed income investment opportunities. The only credible and safe option available is by way of sovereign instruments. Other long-term investments like deep discount bonds where people had invested earlier were with call and put options and most of them have been called. The ones, which have not been called, have seen their credit rating deteriorate to unacceptable levels. Traditional open-end debt funds have a tendency to provide unpredictable returns over a longer term due to their structure where the maturity is not fixed. With the fixed maturity option of Gilt BeES, investors will be able to buy into the fixed maturity they desire to own.

For retail investment in government securities, the investor has an option to deal in the retail debt segment of the NSE. We feel that Gilt BeES can add value as good packaging for direct gilt exposure due to several reasons. For the same maturity, there are multiple securities available and liquidity becomes fragmented. There is also the problem of off-the-run and on-the-run securities which retail investors are not capable of tracking or understanding. Gilt BeES being a mutual fund offer tax advantages. The investor can have cash flow options of either growth or income in Gilt BeES, which are not available in holding securities directly. By choosing the growth option, they are converting a coupon paying security into a zero-coupon bond (with re-investment risk).

The Nifty BeEs faced redemption pressure in early 2002. The corpus was reduced from Rs 10.8 crore (January 31, 2002) to Rs 7 crore (February 2, 2002). Was this redemption due to lack of liquidity?
First of all, the liquidity of ETFs is liquidity of underlying instruments. In case of the Nifty BeES, the trading volume of the underlying is in excess of Rs 1,500 crore everyday. The trading volume has nothing to do with ETF liquidity. Just as in open-end funds, if there is no subscription or redemption, it does not make the fund illiquid. This perception is prevalent with people who have not tried trading themselves. The investors who have traded in the Nifty BeES are using this instrument again and again to take advantage of market fluctuations.

Also, in order to understand the fluctuations in the Nifty BeES corpus, one requires an understanding of how ETFs operate globally.

Typically in the IPO, the seeding is done by the authorised participants (APs). For the Nifty BeES we had seven APs who put Rs 3 crore each in the IPO and, thus, we had a corpus of Rs 21 crore in the IPO. APs are like wholesalers of consumer goods. At the time of launch of the ETF, they will increase inventory levels. Once the demand stabilises, they will keep minimal inventory to satisfy demand. They are not end consumers of ETFs.

Thus, in same manner post-IPO, APs sold some Nifty BeES in the market and returned the excess inventory to the fund. Today, from just seven participants of the IPO we have achieved a considerable investor base and almost the entire corpus is now in the hands of end investors which was zero at the time of the IPO. Since the time we have been listed, the trend is only rising in terms of number of investors using this product.

Also, this being a passively managed fund, the corpus levels in future will change with market perception. If the investor feels that the market is overpriced, the investor will, and should, get out of the fund as being a passive fund, it does not claim to protect investors' capital in the downturn.