Ifs Assignment

8/8/2019 Ifs Assignment

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INDIAN FINANCIAL

SYSTEM

CIA -II

ROLE OF ETF¶S IN THE GROWTH OF INDIAN CAPITAL MARK ET

DO NE BY

HITESH SHAH (0911053)

4TH SEM BBM A



What are ETFs

ETF is def ined as a secur ity that track s an index, a commodity or a basket of assets like anindex fund but trades like a stock on an exchange and exper iences pr ice changes throughout the day as it is bought and sold. ETF were f ir st launched in 1993 in United States. Their popular ity as a structured product has grown immensely because of the benef its it provides to

investor s and trader s. The issuance of EFT is just like a pr imary market IPO or a mutual Fund NFO. Shares are issued by the Fund manager and listed on the exchanges. Investor s can buy and sell these shares from the secondary market through their broker s. ETF are often called asindex shares

An ETF is an investment fund that track s a basket of assets. These could be an index, a commodity or a basket of commodities. ETFs are essentially chunk s or pieces of portfoliosthat investor s trade in instead of stock s. Track ing is achieved by holding all the secur itieswhich make up the class, and in the same proportions. ETFs can be traded like a stock wherein pr ices exper ience changes throughout the day as they can be bought and sold almost anytime dur ing the day.

ETFs were f ir st introduced in 1989 but its growth has picked up only in the last 10 year swherein the assets under management in ETFs in Europe and the US have grown at anaverage annual rate of 40% over the last decade. Figure 1 shows the growth in glo bal ETFassets since the start of the decade. Glo bal ETF assets reached $725 billion by end 2008.Mor gan Stanley estimates, glo bal ETF assets should be worth $2 tr illion by 2012.

ETF is not a new concept in India. There have been two ETFs launched in India one is basedon Sensex which was called S pice and another was launched with Nifty as an under lyingasset, it was gold Nifty Bees. However both these instruments failed to attract the attention of investor s. These instruments allowed the investor s to buy index in the form of shares. The investor s apparently preferred to buy shares included in the index directly by buying index

baskets or purchased index in der ivatives markets. Falling interest rates has forced Indianhousehold to look at other classes of assets to hedge their portfolios as well as improve the yield on their basket of assets. Given the fascination for gold among Indians the current launching of gold-based EFT has o bvious advantages. Gold can be bought like a share onstock exchanges; storage will be done by the Fund manager, no secur ity r isk, no impur ity r isk, and no cost of mak ing char ges. Costs will be low and same channel of trading anddelivery like shares will be used. Innovation of products in Indian markets is welcome. Time will tell whether des pite o bvious advantages Indian saver s will continue to buy gold from

jeweler s and bank s or from the stock exchanges.

Figure-1



Creation of ETFsThe creation of ETFs is initiated by an institutional investor depositing a s pecif ied block of

shares with the ETF to get a f ixed amount of ETF shares. These block s are called creationunits. The institutional investor then can sell all or a part of these ETFs in an exchange where

in retail investor s can trade such ETFs like they would buy or sell any equity stock . To redeem the ETF, the institutional investor will have to deposit all the ETF shares that he

received whiledepositing the block of shares .

Passive Management versus Active ManagementThe philosophy of managing an ETF is what is k nown as passive management where in the fund manager makes minor and per iodic adjustments to keep the ETF in line with the under lying which it is track ing. The pr inci ple of an ETF is to match an index or a commodity instead of beating that index.Hence, an investor one har nesses the benef its of the market, the country, the sector etc. They hel p the investor focus on what is most importantchoice of asset classes. This is in contrast with the mutual funds concept where the fund manager actively tr ies to beat the market.

Role of ETF

There is no denying that ETFs are by far less popular than the traditional mutual funds to which a greater num ber of investor s f lock . This may presuma bly be due to the lack of awareness of the existence of ETF or the more likely reason - the improper under standing of ETF by the average investor .

ETFs generally track indexes. For example, the Nifty or the Bankex are tracked with ETFs.As a result, the retur n s narrowly conf ined to the r ise in the index f igure. The steadily growing population of retail investor s in India, who want to quick ly build wealth, is much

more interested in the non-index shares, where the ear ning potential greater . This is the pr ime cause for ETFs failing to catch the investor ¶s eye.

There are, however, some positive as pects of ETFs. At times when market is over -valued, it will be near ly impossible to beat the index f igures. Then index-based conventional mutualfunds and ETF will decidedly be a more attractive bet than actively-managed funds. It is also important to remem ber that gold ETFs, and real estate ETFs, are unique with no like product in the traditional MF sector .



Invest in India with an India ETF

Investing in an India ETF has become a very popular choice for many investor s. This type of investment allows you to capture some of the potential that lies in the Indian market. Here are the basics of the India ETF and why many investor s are choosing to get involved.

India ETFThe India ETF is an investment that integrates many different secur ities from the Indianmarket. The ETF will purchase a num ber of different stock s from Indian corporations. They then create shares that can be sold to the general pu blic. You can purchase these sharesthrough any standar d brokerage account. This type of investment is very similar to a mutualfund that s pecializes in investing in India

Emerging Market Many investor s like the idea of investing in India because it is considered to be an emer gingmarket. Com bined with China, these two countr ies are becoming very successful f inancially.Whenever a country is going through a per iod of growth like India is, there is su bstantialopportunity for investor s. Many different sector s of their economy will be growing

simultaneously. This allows you to benef it from investing in many different companies in the country.

Diversification

One of the ma jor benef its that you can get by investing in an India ETF is diver sif ication. The ETF is going to handle the investment selection for you. They are going to do their best to purchase stock from many different sector s in the economy. If you were to choose your owninvestments, there is a chance that you would choose a company that would not perform well.You also would not have enough capital to invest in all of the different stock s that it wouldtake to create a diver sif ied portfolio on your own. By utilizing an India ETF, you can poolyour resources together with other investor s and create a diver sif ied portfolio. This will limit the amount of r isk that you have as well as increase the potential retur ns.

Liquidity

Another advantage that you will receive by investing in an India ETF is liquidity. When you invest in this type of secur ity, you are going to be a ble to easily buy and sell shares whenever you want. With the ETF format, you can purchase shares on a stock exchange. This meansthat if you have an online brokerage account, you can buy shares at anytime of the day. By compar ison, if you were to invest in a mutual fund, you would not be a ble to benef it from thissame level of liquidity. With mutual funds, you have to put in an or der and it will be processed at the end of the trading day. You also will not k now the exact value of the mutual

fund shares until your or der is processed. With the ETF, you have the a bility to buy or sellthroughout the day which can hel p you avoid negative consequences. For example, if there was a news announcement that could affect your investments, you could choose to quick ly sell your shares so that you can avoid a loss.



Types of ETFs

1. Based on Market Capitalization: ETFs can be track ing a pool of companies segregated based on their market capitalization

2. Based on Emerging and Developed Markets: ETFs formed to track emer ging economies

like BR IC countr ies or developed companies.

3. Industry Based: ETFs track the trends in pr ices of stock s of a particular industrylike realestate, biotechnology etc.

4. Commodity: ETF that track commodity or commodity indices take advantage from the gains in the commodity market. Gold, Silver, Wheat Sugar

5. Index Based: Companies like S&P and Dow Jones, issue indexes compr ised of stock s related to a particular industry, or shares representing the stock markets

6. Currency ETF: ETF track ing currency or currencies. Ex ETF- Euro Currency Trust

(FXE) was introduced in Dec 2005 which trades on the NYSE. Hence investor s can take exposure in Euro through this fund.

7. Global ETF: There are ETFs track ing indices beyond the domestic markets. Ex s pecif ic regional funds that track fast growing markets in China and Korea.

8. Fixed Income ETF: ETF track ing f ixed income products. ETF in this case may declare and pay dividends.



Advantages of ETFs

ETFs provide investor s with an easy mechanism for diver sif ication, which is also provided by mutual and index funds. In compar ison, ETFs provide some additional benef its which are

mentioned below.

1. Low Cost: The expense ratio (fund operating costs as a percentage of assets under management) of ETFs is lower than actively managed funds due to lower management fees. This is due to the passive management philosophy of ETFs which does not require continuous monitor ing and re balancing of the fund¶s portfolio.ETF¶s management expense is 18% lower than the same for mutual funds. The cost

benef its would be negated by the brokerage char ges dur ing trading, but the net benef it can be increased by balancing investment size with trading frequency.

2. Trading Flexibility: Since ETFs are traded like stock s, their pr ices are continuously updated as trades occur unlike mutual funds which are revalued only at the end

of the day. Thus ETFs permit an active investor to make money out of possible market ineff iciencies through intraday trading. Unlike index and mutual funds,

short selling in ETFs is permitted which implies that an investor could make money even when the market is falling. Since ETFs could be designed to track different

indices, commodities and any desira ble portfolio com bination in the capital market, they provide investor s with plenty of trading options.

3. Tax efficiency: ETFs are more taxeff icient than mutual and index funds due to their transaction structure. Dur ing ETF creation, there are no tax-implications asall transactions are in k ind (no cash transfer takes place). The institutional investor deposits a block of secur ities in exchange for ETF shares which are then sold in the market. Dur ing redemption of lar ge holdings, ETF shares are redeemed with shareshaving the lowest cost basis in the fund, there by minimizing capital gains tax for the ETF. In contrast mutual and index funds may have to sell secur ities they holdfor redemption claims, which results in capital gain tax. Thus existing investor sare affected due to tax implications from the ones exiting the fund, which is not the case in ETFs.

Transparency: ETFs provide trans parency to investor s by disclosing their holdings on a daily basis. The trans parency prevents pr ice mani pulations and hel p investor s make informeddecisions. The advantages of a Traded fund shares are :

The disadvantages of ETFs

Broker and commission costs: ETF are traded through broker s and hence every time brokerage has to be paid which becomes costly affair if regular trades are done.

Premiums and discounts: An ETF might trade at a discount to the under lying shares. Thismeans that although the shares might be doing very well on the bour ses, yet the ETF might be traded at less than the market value of these stock s.



Three Reasons for growth of Indian ETFs

As emer ging market economies continue to draw attention and appeal and are likely to remain at the forefront of glo bal economic growth in the future, India and the ETFs that track the Asian nation have long-term appeal and for good reason.

The Inter national Monetary Fund (IMF) expects the Indian economy to grow by 8.5% thisyear and to continue its expansion in the coming year s. One reason India is expected to continue to witness healthy economic growth is its demographics. To put it bluntly, India is

blessed with a young and capa ble workforce that is relatively well-educated and sk illed in the English language. Furthermore, the Economist states that India¶s dependency ratio, which isthe proportion of children and old people to work ing age adults, is one of the best in the wor ld and will remain so for a generation further ena bling the country to surpass the growth of its r ival emer ging markets over the next quarter century.

A second reason India is likely to see healthy economic growth is due to the strength of its pr ivate companies. India is har dly dependent on state patronage, the fuel behind China¶s

growth, and is pr imar ily fueled by entrepreneur s and business investment. Furthermore,

business conf idence appear s to be r ising in India and IPOs and de bt or igination are starting to reappear bolster ing the nation¶s capital markets.

Lastly, India¶s gover nment has started to address the ma jor issues that could potentially hinder economic growth. The nation¶s overall literacy rate is increasing due to a sur ge incheap pr ivate schools for the poor and the gover nment is focusing on improving masstrans port, power generation, water systems and pollution control.

At the end of the day, India has exceptional potential and could outpace China and other emer ging markets in the long-term future. Some ETFs to play India include:

y The iPath MSCI India Index ETN (INP), which is structured as a senior, su bor dinated

de bt instrument.y The WisdomTree India Ear nings Fund (EPI), which is designed to measure the

performance of companies incorporated and traded in India that are prof ita ble. The ETF holds companies such as Reliance Industr ies and Infosys Technologies (INFY).

y The Power Shares India Portfolio (PIN), which boasts Oil & Natural Gas Corporationand Hindustan Unilever in its top holdings.

y The Market Vector s India Small-Cap Index ETF (SCIF), allowing investor s access to smaller companies in India, which tend to have more localized businesses andear nings growth that are more likely to reap the benef its of increasing purchasing power of the Indian consumer .

Although an opportunity seems to exist in these ETFs, it is equally important to consider the r isk s that are involved. To hel p mitigate the downside effects of these r isk s the use of an exit strategy is important.



Opportunities in Indian MarketTraditionally Indian investor s have been conservative with over 50% preferr ing to keep their

savings in bank deposits as shown in Figure 2. In the last f ive year s, mutual funds have grown at a CAGR of 35% indicating that this is the preferred medium for Indians investing in

capital markets (Figure 3). Des pite this rapid growth, penetration of mutual funds amongretail investor s has been quite low. In a recent survey by K PMG, this has been mainly

attr ibuted to lack of k nowledge among investor s in under standingand selecting from var iouscomplicated schemes. In this scenar io, ETFs provide a much simpler and hassle-free medium for Indian investor s to o btain the same benef its which they would get in a mutual fund.Consider ing the low trading volumes of ETFs in India relative to their foreign counterparts, the f ir st step needed to make this happen is to create awareness a bout ETFs among retailinvestor s. Secondly, investor s need to be provided with more portfolio choices wheninvesting in ETFs. Currently there are a bout only 16 ETFs traded in India. This is in sharp contrast to developed capital markets like US and Europe which have 706 and 753 listedETFs res pectively. A good starting point would be the portfolio allocation of MSCI India relative to MSCI Wor ld (Figure 5). Sector s like IT and Ener gy which have relatively higher

weightage in the index should be given higher pr ior ity by institutional investor s while developing sector s pecif ic ETFs.

Figure 2 - Investment Preferences of Indian Investor

Figure 3: Mutual Funds - NAV in Rs. Cr Figure 4 - K PMG

survey



Challenges of implementing ETFs in India

There are var ious issues that have restr icted growth of ETFs in India and have not allowedthem to s prout as freely as they have in more developed markets such as the US. The main

amongst those can be narrowed down to:

Management Challenges: Most traditional ETFs are passively managed. This work s in the case of ma jor index tracker s and actively traded commodities. But track ing small-cap stock sor corporate bonds which are thinly traded becomes infeasible for passive strategies as the num ber of secur ities required to replicate the sector/index becomes too low and requiresartif icial structur ing. In such cases, active management of the fund remains the only via ble solution. This is also the pr ime reason why many product categor ies in India are underrepresented in terms of ETF availa bility. There are issues, however, with active management. ³Active´ management, by its very nature, would require a higher fundmanagement fee from investor s ± thus mak ing it unattractive for them. Also, the real-time nature of ETFs is affected if the secur ity-selection strategies are intended to be applied dur ing

intra-day trading. It remains to be seen whether a trade-off between letting go of some of the inherent advantages of ETFs and having a more diver sif ied set of ETFs which represent most

sector s in India is feasible or not.

Structuring Issues: Management of ETFs not only involves pick ing of the secur ities that replicate a sector or an index but also replicating the under lying asset even if those secur ities

are not physically availa ble. Most commodity indices are tracked in this way by using say, crude oil call options along with a bond of appropr iate matur ity such that the payoff s are

similar to those of the under lying asset. Equity track ing for sector s that do not allow for direct equity owner shi p (may be due to less common stock being availa ble) can also be performed inthis way ± that is, by using der ivatives to replicate the under lying stock s. This, however, leads to track ing error s which can be attr ibuted to:(1) differences in liquidity between the der ivatives and the under lying markets which leadsto failure of ar bitrage pr icing and(2) most der ivatives engineered using options are susceptible to be pr iced accor ding to their implied volatilities rather than the pr ice of the under lying. Thus, although, ETFs are claimedto ³replicate´ an index ± track ing error s are always present due to ineff icient markets anddifferent pr icing models. To remedy this issue, it requires an increase in the num ber of ETFsoperating in India ± which can lead to standar dization of the f inancial structures being used to replicate individual secur ities.

Fragmentation of equity markets: The traditional stronghold of ETFs has been the equity markets. However, the equity markets in India are extremely fragmented ± the stock scompr ising the popular indices such as the BSE30 and the S&P CNX Nifty are heavily tradedwhile the small-caps are thinly traded leading to ineff icient track ing. This is a pro blem

encountered in the developed markets as well. However, in those markets, the extreme liquidity of the der ivatives market allows for eff icient replication. Therefore, unless the exchange-based der ivatives market in India itself matures to allow hy br id secur ities to be traded, there will always be a challenge for ETF manager s to represent all the sector s of the equity markets.



Exchange capabilities: As mentioned ear lier,ETF replication may require, at times,innovative f inancial engineer ing. This requires multi ple capa bilities of the exchanges

the ETFs are being traded on:(1) All the constituent products mak ing up an ETF structure must have a signif icant volume-

base on the exchange, (2) the exchange should allow the decomposition of a unit ETF or der into its constituent

products automatically ± which will lead to reduced transaction costs, more eff icient straight-through processing and less redundant mar gin account maintenance. Most exchanges in India are not sophisticated enough to allow such features. In the a bsence of these, active management of ETFs and higher fees remain the only option to replicate complex thinly traded secur ities.

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