Exchange Traded Funds (ETFs): A fresh investment perspective

Introduction

Exchange traded funds (ETFs) track an index and trade like a common stock. ETFs can be created out of marketable securities like stocks, bonds, and commodities. These securities can be bought, sold and traded much like common stocks throughout the day.

So why so much buzz about ETFs today?

I spoke to one of the top fund managers working in one of the top Indian Asset Management Companies. According to him if ETFs become popular and grow at the current rate, he would be out of his job (he said sarcastically). Let’s see why his comments were so powerful with available data.

ETFs are often seen as powerful instruments which have potential to replace traditional Mutual Funds (MFs). As per the data gathered from www.etf.com, below is the net inflow of funds into global Mutual Funds and global ETFs on YOY basis and the growth of US ETFs over 2 decades.

Exhibit 1: ETF growth in the US

Above exhibits tell us that ETFs have been becoming popular in recent years.

 How ETFs are created and redeemed?

ETFs are index-based financial instruments created on underlying assets such as equity, debt and commodities. For simplicity, let’s restrict our discussion on ETFs with an underlying asset as equity and ETF tracks Nifty 50 and traded on NSE. The whole process of ETF can be divided into two different steps: creation and redemption mechanism.

Creation process

ETF-company which is a provider of ETF designs the structure of Nifty 50 basket with certain weights given to individual stocks. Authorized participants (APs) are the institutions (Investment banks/ market makers) which have a large buying power, buys underlying physical stocks from the exchanges or use from their own inventory. Then APs pass these underlying reference securities to ETF company. ETF provider creates ETF shares out of the reference shares passed by APs and passes these ETF shares to the APs. APs will distribute these ETF shares in stock exchanges such as NSE and BSE to the investors through brokers.

Redemption process

Suppose if the individual investor sells ETF shares on the exchange, then APs will collect these ETF shares and they will either keep it in their inventory or pass these ETF shares to ETF provider. If APs pass ETF shares to ETF provider, then ETF provider passes underlying reference securities to APs. APs may keep these underlying securities in their own inventory or sell these underlying stocks on the exchange. 

Arbitrage in ETFs

Let’s say there is a huge demand for ETFs in the market and the price of ETFs shoots over the value of underlying assets. In this case, APs will start selling overvalued ETFs in the market and start buying underlying reference securities in the market at the fair value which corrects arbitrage scenario. Here you can notice that APs are profited from arbitrage opportunity and thus are benefited.

Let’s say there is a huge selling pressure for ETFs in the market and the price of ETFs falls below the fair value of underlying reference securities. In this case, APs will start buying undervalued ETFs at a lower price from the market which drives up the price and sell these ETF shares to ETF company at the fair value. Here also APs make profits out of this arbitrage opportunity and corrects the price of ETFs.

So what’s driving ETF space?

1.      Diversification of portfolio

ETF tracks index funds and each ETF has a number of stocks as underlying securities which give the advantage of diversification. Diversification reduces specific risks and protects investors from volatility arising from individual stocks.

2.      Option to choose multiple flavors

An investor gets the option to choose ETFs from multiple sectors and industries. You can have exposure to stocks tracking banking sector, IT, Pharma, mid –cap, small-cap, gold, stocks traded in NASDAQ and Honk Kong and the list goes on.

3.      Diversification out of small capital

ETFs provide an opportunity to diversify portfolio for an investor with a small capital base. Otherwise achieving diversification and gaining exposure to a number of stocks is impossible for an average retail investor.

4.      Low cost compared to mutual funds

Mutual funds are managed by fund managers who charge a huge fee. This huge fee, in turn, gets transferred to investors and so higher cost for investors. But in the case of ETFs, there is no requirement of active fund manager participation as ETFs simply track an index or underlying reference securities distributed in certain weights. Also, ETFs have less processing work compared to MFs.

5.      Flexibility of ETFs over MFs

ETFs are traded like stocks and bonds. You can buy, sell and play intraday in the case of ETFs. But in the case of MFs, you need to keep invested for a specific lock-in period as specified by the fund. This gives flexibility for an ETF investor to allocate funds and decide the period of investment based on his own choice while earning diversification advantage at low cost.

6.      Transparency

MFs usually declare their portfolio on a periodic (usually monthly) basis. This lacks transparency as an investor will not know what tranche of his investment has exposure to a specific stock. But in the case of ETFs, an investor will know his exposure.

An ETF investor will know the value of his investment throughout the trading hours. But an MF investor will come to know his holding value after the end of trading hours.

7.      ETF is a mantra during persistent market volatility

If the market is witnessing persistent volatility and downward trend because of uncertainties in global markets and domestic markets, ETFs give an easy exit option for an investor. But investor will be stuck if he has invested in MFs because of fund withdrawal constraints.

8.      Tax benefit

Let’s say an investor sells ETF in the exchange. APs buy these ETF shares and they may keep ETF shares in their own inventory or pass ETFs to the ETF-company. In return, the ETF-company passes underlying reference assets to APs. The usual practice is to pass underlying assets that have high capital gains. This protects investors from taxes levied on capital gains as the ownership of stocks that have high capital gains is passed on to APs. Also here we can note that APs will attract capital gains tax only if these underlying securities is sold in exchanges.  

You can read the same article and follow my analysis on my personal blogs

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