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Exchange Traded Fund- The New Breed

Anything you might do with a stock, you can do with an Exchange Traded Fund

Few months ago, UTI conceptualised the first Exchange Traded Fund on the BSE Sensex. And now Benchmark AMC, a new entrant is planning foray with its version of ET on the Nifty. Here is a primer on this new kind of fund.

What are Exchange Traded Funds?
While UTI was the first to conceptualise an ETF on the BSE Sensex, the fund is yet to see the light of the day. As the name suggests, ETFs are a basket of securities that are traded, like individual stocks, on an exchange. Unlike regular open-end mutual funds, where one can enter or exit only at the end of the day, ETFs can be bought and sold throughout the trading day. Investors can also hedge their positions in the market by going long and short on ETFs. In a nutshell, anything you might do with a stock, you can do with an ETF. On the other hand, even as these funds are traded on the bourses, the prices of these units should ideally reflect the NAV through out the trading day and thus, the premium and discount associated with close end funds be theoretically avoided. However, in practice, AMCs rely on an arbitrage mechanism and market makers to keep the trading prices roughly in line with the net asset values of their underlying portfolios. Some AMCs also buyback units from the secondary market in order to enhance the NAV.

Another important feature of ETF is that their shares cannot be bought from or sold back to the fund house like regular mutual funds since transactions take place in big block of units. No wonder, this means that only institutions and high networth investors can afford to deal directly with the fund companies. The average investor will have to go through a broker to buy and sell shares. Add to it, ETFs require in-kind transactions--that is, you don't get cash when you redeem units, but get the underlying stocks. Thus, in the case of Nifty BeES, Benchmark Mutual Fund will exchange the underlying stocks in the same weight as they have in the Nifty.

Arbitrage Opportunities:
As has been said above, ETFs do not necessarily trade at the net asset values of their underlying holdings. Instead, forces of supply and demand for the fund determine the market price. To a large extent, the supply and demand for the fund is driven by the underlying value of the portfolios, but other factors do affect market prices. As a result, there is every possibility that ETFs will trade at prices above or below the value of their underlying portfolios. However, what typically happens is that by permitting large investors to buy or redeem shares in-kind, the fund companies behind ETFs create a mechanism that should help prevent sustained discounts or premiums.

Thus, if an ETF traded at a discount to its net asset value, institutional investors could assemble units in the open market at the discounted price, redeem them for the underlying stocks, and sell those stocks at a profit. Clearly, the arbitrage opportunity would generate sufficient demand for the discounted fund to narrow the gap between the market price and the NAV of the underlying portfolio.

The Cost:
Since ETFs are passively managed, they have lower annual expenses that actively managed funds. However, this is just one part of the story. As the case with stocks, an investor buying ETF must pay brokerage to buy and sell in the secondary market. Thus, if you are a regular investor in the mutual fund industry, you may end up paying more than what you would with a regular mutual fund. Similarly, those investors, who trade frequently, would also find their cost inflated.

Passively managed index funds have yet to establish a relevant position in India, where actively managed funds beat indices by huge margins. Hence, there is little appetite for a fund, which merely tracks a stated benchmark. While Nifty BeES is another passively managed index fund, it will be traded on NSE and available to investors in towns and cities with NSE terminals. Besides, as the fund is listed on other bourses, the geographical reach of the product will be further enhanced. Surely, this kind of a product can do wonders for a number of AMCs, which do not have the necessary distribution strength. While index funds may not be a popular concept today, the product is expected to catch on once we have funds tracking a narrow basket of stocks or fast paced indices like the technology index.