Exchange Traded Fund (ETF)

Source: Benchmark Mutual Fund website

ETFs are innovative products that provide exposure to an index or a basket of securities that trade on the exchange like a single stock। ETFs have a number of advantages over traditional openended index funds as they can be bought and sold on the exchange at prices that are usually close to the actual intra-day NAV of the Scheme। ETFs are an innovation to traditional mutual funds as ETFs provide investors a fund that closely tracks the performance of an index with the ability to buy / sell on an intra-day basis। Unlike listed close ended funds, which trade at substantial premiums or more frequently at discounts to NAV, ETFs are structured in a manner which allows to create new units and redeem outstanding units directly with the fund, thereby ensuring that ETFs trade close to their actual NAVs।

ETFs came into existence in the USA in 1993. The first ETFs were based on the S&P 500 and are popularly known as SPDRs (Spiders). ETFs have gained prominence over the last few years.
ETFs are usually passively managed funds wherein subscription / redemption of units work on
the concept of exchange with underlying securities. In other words, large investors / institutions
can purchase units by depositing the underlying securities with the fund / AMC and can redeem
by receiving the underlying shares in exchange of units. Units can also be bought and sold
directly on the exchange.
ETFs have all the benefits of indexing such as diversification, low cost and transparency. As
ETFs are listed on the 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 more,
exchange traded mechanism helps reduce minimal collection, disbursement and other processing charges.
The structure of ETFs is such that it protects long-term investors from inflows and outflows of
short-term investor. This is because the fund does not bear extra transaction cost when buying / selling due to frequent subscriptions and redemptions.

Tracking Error of ETFs is likely to be low as compared to a normal index fund. Due to the
Creation / Redemption of units through the in-kind mechanism the fund can keep lesser funds in cash. Also, time lag between buying / selling units and the underlying shares is much lower.
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.
Benefits of ETFs
1. Can be easily bought / sold like any other stock on the exchange through terminals spread
across the country.
2. Can be bought / sold anytime during market hours at prices that are expected to be close
to actual NAV of the Scheme. Thus, investor invests at real-time prices as opposed to end
of day prices.
3. No separate form filling for buying / selling units. It is just a phone call to your broker or
a click on the net.
4. Ability to put limit orders.
5. Minimum investment for an ETF is one unit.
6. Protects long-term investors from the inflows and outflows of short-term investors.
7. Flexible as it can be used as a tool for gaining instant exposure to the equity markets,
equitising cash, hedging or for arbitraging between the cash and futures market.
8. Helps in increasing liquidity of underlying cash market.
9. Aids low cost arbitrage between Futures and Cash market.
10. An investor can get a consolidated view of his investments without adding too many
different account statements, as Nifty BeES will be in demat form.
Uses of ETFs
1. Investors with a long-term horizon
Allows diversification of portfolio at one shot thereby reducing scrip specific risk at a
low cost.
2. FIIs, Institutions and Mutual Funds
Allows easy asset allocation, hedging, equitising cash at a low cost.
3. Arbitrageurs
Low impact cost to carry out arbitrage between the Cash and the Futures market.
4. Investors with a shorter term horizon
Allows liquidity due to ability to trade during the day and expected to have quotes near
NAV during the course of trading day.
Risks of ETFs
1. Absence of Prior Active Market: Although the units of ETFs are listed on the Stock
Exchange for trading, there can be no assurance that an active secondary market will
develop or be maintained.
2. Lack of Market Liquidity: Trading in units of ETFs on the Stock Exchange on which it
is listed may be halted because of market conditions or for reasons that, in the view of the
concerned Stock Exchange or Market Regulator, trading in the ETF Units is inadvisable.
In addition, trading in the units of ETFs is subject to trading halts caused by extraordinary
market volatility pursuant to ‘circuit breaker’ rules. There can be no assurance that the
requirements of the concerned Stock Exchange necessary to maintain the listing of the
units of ETFs will continue to be met or will remain unchanged.
3. Units of Exchange Traded Funds May Trade at Prices Other than NAV: Units of
Exchange Traded Funds may trade above or below their NAV. The NAV of Units of
Exchange Traded Funds may fluctuate with changes in the market value of a Scheme’s
holdings. The trading prices of units of ETF will fluctuate in accordance with changes in
their NAVs as well as market supply and demand. However, given that ETFs can be
created / redeemed in Creation Units, directly with the fund, large discounts or premiums
to the NAVs will not sustain due to arbitrage possibility available.