This is the 1st installment of our 2 part series on ETFs.

What are ETFs?

ETFs are a basket of securities that are listed and traded on a recognised stock exchange. Simply put, they are mutual funds, whose units can be bought and sold on the stock exchange. ETFs can be either passively managed or actively managed.

A passively managed ETF attempts to replicate the performance of its underlying benchmark index (like the S&P CNX Nifty, for instance). It invests in the same stocks as the index and in the same weightage as well. The intention is to track the index as closely as possible (i.e. with least deviation).

On the contrary, an actively managed ETF can freely invest in stocks/securities, within the guidelines laid down by its investment mandate. In other words, the fund has no obligation to invest in the same stocks/securities as its benchmark index. The intention is to outperform the benchmark index.

However, it must be noted that the defining feature of ETFs is not whether they are passively or actively managed, but that they are traded on the stock exchange.

ETFs in India

ETFs first made their presence felt in India in the year 1994 with the launch of Morgan Stanley Growth Fund, a close-ended, actively managed, diversified equity fund. However, the dismal track record of the fund combined with a price history that was trading perpetually at discount to the NAV, gave investors the wrong signal as far as ETFs were concerned. Investors began perceiving ETFs as poorly managed and felt short-changed when they sold their units at a steep discount to the NAV.

Things changed after the launch of Nifty Benchmark Exchange Traded Scheme-Nifty BeES (launched in December 2001), an open-ended, passively managed fund. It would be fair to say that the fund set the records straight for ETFs in the country. Since then, the ETF segment has grown slowly but steadily. Recently, the launch of gold ETFs has provided the much needed zing to the segment, thus attracting many investors.

ETFs at present have a fair variety to offer. For example, among others, there are ETFs like Quantum Index Fund and ICICI SPIcE Fund that track broad indices such as the S&P CNX Nifty and the BSE Sensex respectively. Then there is Bank BeES (from Benchmark Mutual Fund), an ETF that tracks CNX Bank Index. On the debt side, there is Liquid BeES that invests in a basket of call money, short-term government securities and money market instruments. And there are several gold ETFs to choose from. Going forward, investors can only expect the bouquet of ETF offerings to grow.

How ETFs function

Given that an ETF is traded on the stock exchange, its price may not necessarily be the same as the NAV of the underlying portfolio. In other words, an ETF could have an NAV distinct from its market price. The reason being that the market price is usually driven by the demand and supply of units. Hence there is a distinct possibility of an ETF’s units trading at a premium or discount to its NAV.

Unlike regular mutual funds, where the investor deals directly with the AMC (asset management company), in case of ETFs, a bulk of the buying and selling is done over the stock exchange. Direct dealing with the AMC is possible only if the transaction is done in specified lot sizes known as ‘creation units’. Since the creation units are comprised of a large number of units, they are not viable propositions for retail investors. It is possible only for institutions and wealthy individuals to deal directly with the AMC. While dealing with the AMC, such investors can avail of ETF units by delivering the stocks (assuming that the ETF tracks a stock index) that make up the underlying index; also ETF units can be exchanged for the underlying stocks.

AMCs attempt to keep the market price of the ETF close to its NAV; for this purpose, they appoint institutions commonly referred to as market makers. These market makers try to benefit from any premium or discount between the ETF’s market price and its NAV, by performing an arbitrage between the ETF and its underlying portfolio. So how does this mechanism work? If an ETF is trading at a discount to its NAV, then the market maker will buy ETF units from the stock market and then sell the same to the AMC (in creation units); after taking delivery of the underlying stocks, the market maker will sell the same in the stock markets, thereby benefiting from the arbitrage opportunity. The converse will be done when an ETF is trading at a premium to its NAV. The arbitrage mechanism helps to keep the market price of an ETF close to its NAV.