Exchange Traded Funds (1)

8/8/2019 Exchange Traded Funds (1)

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Exchange Traded FundsExchange Traded Funds

L.Parvathi AishwaryaPGDMBIF-024


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Exchange Traded Funds

y An ETF is a basket of securities that is traded on the stock exchange, akin to a

stock. ETFs are listed on a recognized stock exchange. Their units can be

bought and sold directly on the exchange, through a stockbroker during the

trading hours.

y ETFs can be either close-ended or open-ended. Open-ended ETFs can issue

fresh units to investors even post the new fund offer stage, although this tendsto happen selectively on account of the substantial lot sizes involved. In case

of ETFs, since the buying and selling is largely done over the stock exchange,

there is minimal interaction between investors and the fund house


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ETFs can be either actively or passively managed. In an actively-managed ETF,

the objective is to outperform the benchmark index. On the contrary, a passively-

managed ETF attempts to replicate the performance of a designated benchmark

index.

In the Indian context, passively managed ETFs are more prominent.

y ETFs first came into existence in the USA in 1993.

y Benchmark Asset Management Company Pvt Ltd. (BAMC),

a SEBI registered Asset Management Company is the first company to Launch

ETFs in India. It was launched in 2001. It was listed on the Nifty for trade.

y Regulator: SEBI


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Structuring of an ETF

Primary Market

SecondaryMarket

Authorised Participant/Financial Institution

Fund

Seller

NSE

Buyer

Buy/Sell

Market making/Arbitrage

Creation inkind

Redemption in kind

Cash

Cash

ETF Units

ETF Units


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y The open ended side of an ETF is restricted to a limited set of participants

called Authorised Participants and a certain minimum size is prescribed for the

creation/redemption of units.

y The creation/redemption of units happens in kind. Authorised Participants

who want new ETF units have to pay in the form of a basket of stocks that

mirrors the underlying index. Likewise, when Authorised Participants want the

ETF units to be redeemed they are paid in the form of a basket of stocks

mirroring the underlying index.

y As ETF units are listed on the secondary market (like NSE) investors can buy

and sell ETF units in cash.


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y In the secondary market, ETF tend to trade very near to their Net Asset Value

(NAV).

If the market price of ETF units exceeds their NAV, Authorised Participants

would sell ETF units from their inventory, buy the underlying basket of

stocks from the exchange, and deliver the basket of stocks to the ETFs to

replenish their inventory of ETF units and make an arbitrage profit.

Likewise, if the market price of ETF units is less than their NAV, Authorised

Participants would buy ETF units from the market, redeem the units with

the ETF, get the underlying basket of stocks, and sell the same in the market

to make an arbitrage profit.


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Index ETFs : These are index funds that hold securities and attempt to replicate

the performance of a stock market index.

Commodity ETFs: Commodity ETFs invest in commodities, such as precious

metals and futures on commodities. These ETFs are sometimes called ETCs

(Exchange Traded Commodities)

Currency ETFs : These funds track all major currencies under their brand

currency shares.

Types of Exchange Traded Funds


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Actively Managed ETFs : These ETFs are of recent origin, which were offered on

25th March, 2008 in US. These are fully transparent funds , which publish their

current securities portfolio on their website daily. They try to outperform the

benchmark index, whereas passively-managed ETFs attempt to replicate the

performance of a designated benchmark index.

Leveraged ETFs : These funds try to achieve returns that are more sensitive to

market movements than non-leveraged ETFs. Leveraged ETFs can be used by

active traders to play short-term market movements

All-World ETFs. An investor can now achieve global equity diversification by

investing in one ETF. All world ETFs provide coverage on most of the stock

exchanges in both developed and emerging markets.


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Sector ETFs: Sector ETFs allow investment in the stocks of different industrial sectors.

Investors can use the sector ETFs either as building blocks for a portfolio or to make

specific sector bets, like investing in energy or technology stocks. Building a portfolio withsector ETFs, versus a broad based ETF, can provide for more fine-tuning of a portfolio.

Broad-Based Bond ETFs As with a stock ETF, investors can buy a broad-based bond ETF

containing a broad mix of both government and corporate bonds at different maturities. A

broad-based bond ETF can form a core component of a bond portfolio.

Market Capitalization ETFs: One way of looking at stocks is based on their market

capitalizations. Many experts divide the market into large cap, mid cap, and small cap

stocks. Rather than buying a broad-based ETF, an investor can fine tune the strategy by

buying three ETFs: a large cap, a mid cap and a small cap. This approach provides for

greater customization opportunities than buying just one.


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Inverse ETFs: Investing in an inverse ETF means that you profit from a decline in the

value of an underlying benchmark, such as the NASDAQ.

Yield Curve Bond ETFs Some bond funds allow investors to buy Treasury bonds based on

different maturities along the yield curve. The longer Treasury ETFs are good for

speculating on changes in interest rates, while the short-term bond funds are a good place to

park money that typically provides a better return than money market funds.

Inflation Protected Bond ETFs: Treasury inflation protected securities (TIPS) bonds pay

interest equal to the Consumer Price Index plus a premium. They provide a hedge against

inflation and are designed to outperform regular bonds when inflation expectation rises.


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Quantitatively based ETFs use enhanced indexing to offer investors the potential

to outperform a benchmark index. The objective is to quantitatively identify a

subset of stocks from an index that are expected to outperform. Quantitative

indexing uses predefined rules to rank stocks based on a number of different

characteristics, which can include both fundamental and technical factors.


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Applications of ETFs

y Efficient Trading : ETFs provide investors a convenient way to gain market exposure

viz. an index that trades like a stock. In comparison to a stock, an investment in an ETF

index product provides a diversified exposure to the market. Depending on the index,

investors may obtain exposure to countries/ markets or sectors.

y Equitising Cash : Investors with idle cash in their portfolios may want to invest in a

product tied to a market benchmark like an index as a temporary investment before

deciding which stocks to buy or waiting for the right price.

y Managing Cash Flows : Investment managers who see regular inflows and outflows

may use ETFs because of their liquidity and their ability to represent the market.


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y Diversifying Exposure : If an investor is not sure about which particular

stock to buy but likes the overall sector, investing in shares tied to an index

or basket of stocks provides diversified exposure and reduces stock specific

risk.

y Filling Gaps : ETFs tied to a sector or industry may be used to gain

exposure to new and important sectors. Such strategies may also be used to

reduce an overweight or increase an underweight sector.

y Shorting or Hedging : Investors who have a negative view on a market

segment or specific sector may want to establish a short position to

capitalize on that view. ETFs may be sold short against long stock holdings

as a hedge against a decline in the market or specific sector.


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ETFs Vs Stocks & Mutual FundsFunctionality ETFs Stocks Mutual Fund

Units

Real time trading and pricingthroughout market hours

Yes Yes No

Abilityto put limit orders Yes Yes No

Can be purchased through NSEbroker and/or online tradingaccount

Yes Yes No

Can be traded real time on the NSE Yes Yes No

Arbitrage possible between futuresand cash market

Yes Yes No

Diversification possiblewith a

single unit

Yes No Yes

Returns at parwith themarket/index

Yes No Yes

Intraday Trading Yes Yes No

Paper less trading Yes Yes No

Exit load No No Yes


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Advantages of ETFs

y Buying and selling flexibility: ETFs can be bought and sold at current market prices at

any time during the trading day

y

Transparency - ETFs, whether index funds or actively managed, have transparentportfolios and are priced at frequent intervals throughout the trading day

y Delivery in demat accounts

y Minimum trading lot just one unit

y One can put limit orders


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Disadvantages of ETFs

y Brokerage has to be paid for trading in ETFs

y Investors need to have a demat and a trading account, with a SEBI registered

stockbroker, for investing in ETFs.


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Exchange Traded Funds (1)

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