Project on Capital Markets

Exchange Traded Funds

Submitted by:
Swati Agarwal (4811)
Table of contents

[Link]. Topic

1 Introduction

2 How does an ETF work?

3 Structure of ETFs in India

4 What motivates each player?

5 Comparison with conventional MFs

6 ETF’s Woes in India

7 Types of ETFs

8 Study - Gold ETF

Introduction
What are Exchange Traded Funds?
Definition- An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges,
much like stocks or bonds. An ETF holds assets such as stocks, bonds, or futures. Institutional investors
can redeem large blocks of shares of the ETF (known as "creation units") for a "basket" of the
underlying assets or, alternatively, exchange the underlying assets for creation units. This creation and
redemption of shares enables institutions to engage in arbitrage and causes the value of the ETF to
approximate the net asset value of the underlying assets. Most ETFs track an Index, such as the Dow
Jones Industrial Average or the S&P 500.

An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be
purchased or redeemed at the end of each trading day for its net asset value, with the tradability feature
of a closed-end fund, which trades throughout the trading day at prices that may be substantially more or
less than its net asset value. Closed-end funds are not considered to be exchange-traded funds, even
though they are funds and are traded on an exchange. ETFs have been available in the US since 1993
and in Europe since 1999. ETFs traditionally have been Index funds, but in 2008 the U.S. Securities and
Exchange Commission began to authorize the creation of actively-managed ETFs.

How does an ETF work?

In a normal fund we buy/sell units directly from/to the AMC. First the money is collected from the
investors to form the corpus. The fund manager then uses this corpus to build and manage the
appropriate portfolio. When you want to redeem your units, a part of the portfolio is sold and you get
paid for your units. The units in a conventional MF are, therefore, called ‘in-cash’ units.

But in ETF, we have something called the ‘authorized participants’ (appointed by the AMC). They will
first deposit all the shares that comprise the index (or the gold in case of Gold ETF) with the AMC and
receive the ‘creation units’ from the AMC. Since these units are created by depositing underlying
shares/gold, they are called ‘in-kind’ units.

These creation units are a large block, which are then split into small units and accordingly bought/sold
in the open market on the stock exchange by these ‘authorized participants’.

Therefore, technically every buy and sell need not change the corpus of an ETF unlike a conventional
MF. However, as and when there is more demand, these authorized participants deposit more shares
with the AMC and get more creation units to satisfy the demand. Or if there is more redemption, then
they give back these creation units to the AMC, take back their shares, sell them in the market and pay
the investor.

Thus Investors who want to sell their ETF shares have two options: They can sell individual shares to
other investors on the secondary market, or they can sell the Creation Units back to the ETF.
Structure of ETFs in India
The creation of an ETF begins with an authorized participant, also referred to as a market maker or
specialist. Highly scrutinized for their integrity and operational competence, these middlemen assemble
the appropriate basket of stocks and send them to a specially designated custodial bank for safekeeping.
These baskets are normally quite large, sufficient to purchase 10,000 to 50,000 shares of the ETF in
question. The custodial bank double-checks that the basket represents the requested ETF and forwards
the ETF shares on to the authorized participant. This is a so-called in-kind trade of essentially equivalent
items that does not trigger capital gains for investors.

The custodial bank holds the basket of stocks in the fund's account for the fund manager to monitor.
There isn't too much activity in these accounts.

This flow of individual stocks and ETF certificates goes through the Depository Trust Clearing Corp. It
records ETF transfer of title just like any stock. It provides an extra layer of assurance against fraud.

Once the authorized participant obtains the ETF from the custodial bank, it is free to sell it into the open
market. From then on ETF shares are sold and resold freely among investors on the open market.

Redemption is simply the reverse. An authorized participant buys a large block of ETFs on the open
market and sends it to the custodial bank and in return receives back an equivalent basket of individual
stocks which are then sold on the open market or typically returned to their loaners.
What motivates each player?
The fund manager takes a small portion of the fund's annual assets as their fee, clearly stated in the
prospectus available to all investors. The investors who loan stocks to make up a basket make a small
interest fee for the favor. The custodial bank makes a small portion of assets likewise, usually paid for
by the fund manager out of management fees. The authorized participant is primarily driven by profits
from the difference in price between the basket of stocks and the ETF and on part of the bid-ask spread
of the ETF itself. Whenever there is an opportunity to earn a little by buying one and selling the other,
the authorized participant will jump in.

The process might seem cumbersome but it does allow for transparency and liquidity at modest cost.
Everyone can see what goes into an ETF, investor fees are clearly laid out, investors can be confident
that they can exit at any time, and even the authorized participant's fees are guaranteed to be modest. If
one allows ETF prices to deviate from the underlying net asset value of the component stocks, another
can step in and take profit on the difference, so their competition tends to keep ETF prices very close to
it underlying Net Asset Value (Value of Component Stocks).

ETFs provide exposure to an index or a basket of securities that trade on the exchange like a single
stock. They offer a number of advantages over traditional open-ended index funds as follows:

1. While redemptions of Index fund units takes place at a fixed NAV price (usually end of day),
ETFs offer the convenience of intra-day purchase and sale on the Exchange, to take advantage
of the prevailing price, which is close to the actual NAV of the scheme at any point in time. They
provide investors a fund that closely tracks the performance of an index throughout the day with
the ability to buy/sell at any time, whereby trading opportunities that arise during a day may be
better utilized.

2. They are low cost. Unlike listed closed-ended funds, which trade at substantial premia or more
frequently at discounts to NAV, ETFs are structured in a manner which allows Authorized
Participants and Large Institutions to create new units and redeem outstanding units directly with
the fund, thereby ensuring that ETFs trade close to their actual NAVs.

3. ETFs are like any other index fund, wherein, subscription / redemption of units work on the
concept of exchange with underlying securities instead of cash (for large deals).

4. Since an ETF is listed on an Exchange, costs of distribution are much lower and the reach is
wider. These savings in cost are passed on to the investors in the form of lower costs. Further, the
structure helps reduce collection, disbursement and other processing charges.

5. ETFs protect long-term investors from inflows and outflows of short-term investors. This is
because the fund does not incur extra transaction cost for buying/selling the index shares due to
frequent subscriptions and redemptions.
6. Tracking error, which is divergence between the NAV of the ETF and the underlying Index, is
generally observed to be low as compared to a normal index fund due to lower expenses and the
unique in-kind creation / redemption process.

7. ETFs are highly flexible and can be used as a tool for gaining instant exposure to the equity
markets, equitising cash or for arbitraging between the cash and futures market.

8. Tradable and Diversifiable: The ultimate selling proposition of an ETF lies in its twin feature of
being tradable and diversifiable. One can trade a stock but then it is not diversifiable. Or, one can
buy a mutual fund and thereby diversify but then the mutual fund would not be tradable.
Alternatively, one can diversify one's risks by holding a portfolio of stocks and trade them but that
would be too much of a botheration for the lay investor. These conflicts are reconciled by an ETF
that is at once tradable and is a diversified portfolio too. It is these two features, working in
tandem, like the twin blades of a scissor that make it a financial product of choice.

9. Transparency: Just like the index fund, the portfolio of an index fund has no mystery to it.
Everybody in the participating market is aware of the stocks that it is tracking and therefore need
not worry about a change in the stocks being traded in.

10. Makes multiple trading strategies possible: As has been said earlier, ETFs have the utility of
doubling up as arbitraging instruments between the futures and cash markets. It also helps in
equitizing cash, i.e., changing cash into equities, at a low cost.

11. A Bear market friend: In a volatile stock market, an ETF might become an instrument of choice
as it is not expected to be as volatile and yet may be traded. This is borne out by the fact that the
assets of US ETFs have grown from $ 96 billion in January 2003 to $118 billion in May 2003.

Comparison with conventional MFs

1. Since all ETFs require certain specific shares to be deposited for units to be created, they all are
usually index-specific like Nifty, Sensex, Bankex etc. As against this, a conventional MF can have
any portfolio (though as per the pre-defined objective). Of course index funds will also mimic the
index and hence to that extent ETFs & index funds are same

2. Because ETFs are index-specific, the portfolio remains more or less constant, whereas portfolio of
an actively managed conventional MF will change on day-to-day basis. Hence, while portfolio of
ETF is known beforehand, the portfolio of a conventional MF can be known only at the time of
month-end disclosures.

3. ETFs are bought/sold on the stock exchange and need a demat account. Conventional MFs are
bought/sold from/to the AMC.
4. ETFs can be traded like a stock at any time of the day and at real-time prices, while the market is
open. Whereas, one can buy MFs only at the NAV based on the closing prices.

5. The unit capital of close-ended funds (and even shares) will not change with trading. But unit capital
of ETF can change with trading and hence to that extent they behave like open-ended funds

6. There are some close-ended funds listed on the exchange. But because they are structurally different
from an ETF, they can trade at substantial discount (or premium) to the NAV. This will not be the
case with ETFs.

7. Like conventional MFs, they offer the benefits of diversification

8. In ETF, AMCs need not keep a large portion in cash to meet redemption pressures

9. Also, unless there is a huge redemption pressure, shares need not be sold to generate cash to meet the
redemptions – the normal buying & selling of units amongst the investors will take care of day-to-
day redemptions. To that extent, ETFs are somewhat protected

10. In ETF each investor pays his share of costs, unlike conventional MFs where costs are deducted
from the NAV on an average basis. As such the long-term investors suffer, while short-term
investors end-up paying lesser costs in conventional MFs.

ETF’s Woes in India

• The 10% STCG tax, applicable on all gains realised before 12 months, is a ‘prohibitive’
deterrent.

• ETFs normally transfer securities to create tradable units. In India, FII’s cannot transfer
securities without cash moving at the same time.

• Ceiling on foreign ownership of Indian stocks—if an index stock has no ADR, ETFs can’t track
the index.

• Changing and ambiguous taxation policies.

• Need to acquire a licence preclude smaller ETF players from entering.

Types of ETFs
ETFs can be broadly classified as Indexed ETFs and Actively managed ETFs.

Indexed ETFs: Indexed ETFs (sometimes referred to as Classical ETFs) typically offer low
management fees, since they have a low operating cost structure. Reasons for the low cost :The fund
manager does not have to exercise a high level of administration, as investors wanting to buy or sell
units can only do so on a particular index (such as the S&P/ASX 200). The turnover of underlying
shares in the portfolio is minimal as the fund tracks a share market index. In addition, once the target
investment portfolio is established, there is no ongoing need for the ETF manager to undertake research,
since the portfolio composition is determined by the index.

Actively Managed ETFs: Actively managed ETFs provide access to a much broader range of
investment management styles, strategies, asset classes and operational practices than indexed ETFs.

Additionally, actively managed ETFs can usually accept cash applications, which means investors, can
buy units directly from the fund manager through lodging an application form contained in the fund
prospectus as well as to buy units already issued on that index.

Sector ETFs: Almost one third of the available ETFs give you exposure to sectors. These are industry
groups such as communications, financial, health care, natural resources, precious metals, real estate,
technology, and utilities. These sectors can be volatile and often go from media darlings to fallen stars
rather quickly, but they also give investors an easy way to climb aboard a hot trend.

International ETFs

The major country indexes of many third-world countries have brought investors first-class returns in
recent years. ETFs tracking China and Brazil have been among the biggest winners. You can diversify
with broad emerging market ETFs which invest around the globe or focus on key regions such as Asia,
Europe and Latin America.

Commodities ETFs

Oil and gold prices have recently smashed their all-time records, and ETFs that track those commodities
have become very popular. A shortage of raw materials and the rapid growth of countries like China
have also driven up prices of other commodities. ETFs focusing on agricultural commodities are also
gaining steam.
Bond ETFs

Again, there are a lot of choices here, including short-term, intermediate-term, and long-term
government bonds. Other options: corporate bonds, municipal bonds, and emerging market bonds.

Currency ETFs

One can use ETFs to wager on the direction of the yen, euro, dollar, and about a dozen other currencies.

Bear Market ETFs

These ETFs gain popularity when markets start to go down. They make gains when the index they cover
loses value. For example, if the S&P 500 falls in price, ETFs that directly track it like the SPDR S&P
500 will suffer losses, while ETFs like UltraShort S&P500 ProShares that short the index will make
gains.
Study - Gold ETF
Gold ETFs provided investors a means of participating in the gold bullion market without the necessity of taking
physical delivery of gold, and to buy and sell that participation through the trading of a security on stock
exchange. Gold ETF would be a passive investment; so, when gold prices move up, the ETF appreciates and
when gold prices move down, the ETF loses value.
Gold ETF tracks the performance of Gold Bullion. Gold ETFs provide returns that, before expenses, closely
correspond to the returns provided by physical Gold. Each unit is approximately equal to the price of 1 gram of
Gold. But, there are Gold ETFs which also provide a unit which is approximately equal to the price of ½ gram of
Gold.

Why invest in Gold ETF?

 No worry on adulteration
 Gold provides diversification to the portfolio
 Gold is considered as a Global Asset Class
 Gold is used as a Hedge against Inflation
 Gold is considered to be less volatile compared to equities
 Held in Electronic Form
 Store of value
 Extremely Liquid

Advantages of Investing in Gold ETFs

 Potentially cheaper to have price exposure to gold price as compared to other available avenues
 Quick and convenient dealing through demat account
 No storage and security issue for investors
 Transparent pricing
 Taxation of Mutual Fund
 Can be traded on stock exchange like buying / selling a stock
 Ideal for retail investor as minimum lot size to trade is one unit on secondary market
 NAV of a unit will track price of approximately ½ or 1 gram of gold

Here is how some ETF’s Listed on NSE moved over the past two years.
Comparison of Gold ETF with Physical Gold

S
Parameter Jeweller Bank Gold ETF
No

Dematerialized (Electronic
1 How Gold is held Physical (Bars / Coins) Physical (Bars / Coins)
Form)

Differs from one to

Differs from bank to Linked to International Gold
2 Pricing another. Neither
bank. Not Standard. Prices and very transparent.
transparent nor standard.

Buying Premium
3 Likely to be more Likely to be more Likely to be less
above gold price

4 Making Charges Charges are incurred Charges are incurred No Charges are incurred

5 Impurity Risk High Nil Nil

Storage
6 Locker / Safe Locker / Safe Demat Account
Requirement

Fund House takes the

7 Security of Asset Investor is responsible Investor is responsible
responsibility

Conditional and
8 Resale Banks do not buy back At Secondary Market Prices
uneconomical

Less convenient, as Gold Less convenient, as More Convenient, as held in

Convenience in
9 needs to be moved Gold needs to be moved electronic form under the
Buying / Selling
physically physically demat account

Quantity to Buy / Available in standard Available in standard Minimum is ½ or 1 gram

10
Sell denomination denomination according to the fund

11 Bid Ask Spread Very High Can’t Sell Back Very Low

12 Risk of Theft Yes, possible Yes, possible No, Not possible

13 Wealth Tax Yes Yes No

Long Term
14 Only after 3 years Only after 3 years After 1 year
Capital Gains Tax
Investor Requirements for trading in Gold ETF

 Trading account with a stock exchange broker

 Demat account as Gold ETF can be traded only in demat form
 Settlement: The transactions are settled with T+2 rolling settlement

Load Structure

Entry Load: Nil

Exit Load: Nil

Tax treatment of Gold ETF

The Gold ETF is classified under mutual fund and will be taxed as per non equity mutual fund taxation
rules. Investor has to pay taxes after redemption as per the tax laws applicable for non equity mutual
fund. But, when the Gold ETF is redeemed for physical gold the taxation rules will be similar to that of
physical gold.

Following is the taxation slab:

Category Short Term Capital Long Term Capital Dividend Security Transaction Tax
Gain Tax Gain Tax Distribution Tax

Individual As per income tax 10% or 20% with 0.125%

14.16%
slabs indexation at redemption

Corporate 10% or 20% with 0.125%

30% 22.66%
indexation at redemption

NRI As per income tax 10% or 20% with 0.125%

14.16%
slabs indexation at redemption
Observations about Gold ETFs - During Jan 2008 Market Fall

From the above chart we can assume that Gold ETFs in India performed exceptionally well when the market fell
as shown by the green line (an over performance of 15.52% in 3 months).

Risks Involved

 As with any investment in securities, the NAV (Net Asset Value) of the units issued under the
ETF can go up or down depending on the factors and forces affecting the Bullion Market,
Capital Market and Money Market.
 The Past Performance of the fund house issuing the ETF should not be construed for the future
performance of the fund. It might not provide a basis of comparison with other investments.
 The name of the Gold ETF doesn’t indicate the quality of the scheme or its future prospects and
the returns. Investors should study the terms of offer carefully and consult their investment
advisor before investing the scheme.
 ETFs are a new concept in India compared to other parts of the world.
 The sponsor of the mutual fund is not responsible or liable for any loss or shortfall resulting from
the operation of the fund beyond the initial contribution made by it of an amount of Rs 1 Lac
towards setting up of the Mutual Fund.
 Investors are not offered any guaranteed or assured returns.
 The scheme NAV will react to the Bullion Market movements. The investor could lose money
over short periods due to fluctuation in the schemes NAV in response to factors such as
economic and political developments, changes in interest rates and perceived trends in Bullion
market movements and over longer periods during market downturns.