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Exchange Traded Funds in India

An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much

like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to

its Net Asset Value over the course of the trading day. Most ETFs track an index, such as

the S&P 500 or MSCI EAFE. ETFs may be attractive as investments because of their low

costs, tax efficiency, and stock-like features. ETFs are the most popular type of exchange-

traded product.

Exchange Traded Funds (ETFs) have been in existence in India for quite some time now.

Apart from Benchmark AMC, which specializes in ETFs, there have been a couple of ETFs

from Prudential ICICI AMC and UTI AMC.

But so far ETFs have not enjoyed the kind of popularity that the conventional Mutual Funds

enjoy.

One reason could be the lack of understanding of the concept of ETF amongst the general

investor.

Second, and probably the more important reason, is that ETFs by nature track a certain index

(e.g. Nifty or the Bankex). Hence, the returns one can expect from ETFs will be equal to the

rise in the index. Whereas, India is a growing market and hence offers huge opportunities inthe non-index shares too. Therefore, it is not difficult for an active fund manager to beat the

index and offer better returns. As such ETFs (and index-funds too, by that logic) have

comparatively negligible AUMs.

Two things could, however, make ETFs popular in India

One, of course, is that as market valuations become fairly or over-valued, it will becomemore & more difficult to beat the index. Then index-based funds (both conventional MFs &

ETFs) may become a better option than actively-managed funds

Gold ETFs or Real-Estate ETFs have no comparable product in the conventional MF sector,and hence become the only MF route to invest in such markets

Heres an interesting live example. About 1-2 years ago the banking sector was not very

popular. But with the rise in interest rates and the general economic growth, bank stocks were

becoming quite popular. As a result the only banking index fund viz. Benchmark AMCs

the Banking BeEs (there are few banking sector funds but not bank-index funds) saw a jump

of AUM from about Rs.370 crores in June 2005 to almost Rs.7,400 crores by December


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2006. This makes it the largest MF scheme, much higher than about Rs.5000 crores Reliance

Equity Fund.

What are ETFs? How are they different for a normal MF? Are they worth investing? We look

at the answers to these and some other common queries regarding the ETFs.

What are ETFs?

As the name suggests, ETFs are a mix of a stock and a MF in the sense that

Like mutual funds they comprise a set of specified stocks e.g. an index like Nifty/Sensex ora commodity e.g. gold; and

Like equity shares they are traded on the stock exchange on real-time basis.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 what is called the creation units from the AMC.Since these units are created by depositing underlying shares/gold, they are called in-kind

unitsThese 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.

All this may seem to be a bit complicated and time-consuming. But, in effect, it is all system

driven and hence happens on real-time basis with minimal effort & cost.

Comparison with conventional MFs

Let us now look at how similar & dissimilar the ETFs are vis--vis the conventional MFs.


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1. Since all ETFs require certain specific shares to be deposited for units to be created, they allare 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, whereasportfolio 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 MFsare 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 themarket 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 unitcapital 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 structurallydifferent 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 diversification8. As financial instruments per se, ETFs are as safe as conventional MFs. But, of course, the

market risk remains.

9. In ETF, AMCs need not keep a large portion in cash to meet redemption pressures10.Also, unless there is a huge redemption pressure, shares need not be sold to generate cash to

meet the redemptionsthe normal buying & selling of units amongst the investors will take

care of day-to-day redemptions. To that extent, ETFs are somewhat protected

11.In ETF each investor pays his share of costs, unlike conventional MFs where costs arededucted 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.

Benefits of investing in ETFs

Convenient to trade as it can be bought/sold on the stock exchange at any time of the daywhen the market is open (index funds can be bought only at NAV based on closing prices)

One can short sell an ETF or buy on margin or even purchase one unit, which is not possiblewith index-funds/conventional MFs


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ETFs are passively managed, have low distribution costs and minimal administrative charges.Hence most ETFs have lower expense ratios than conventional MFs

Not dependent on the fund manager Like an index fund, they are very transparent

Disadvantages of investing in ETFs

SIP in ETF is not convenient as you have to place a fresh order every month Also SIP may prove expensive as compared to a no-load, low-expense index funds as you

have to pay brokerage every time you buy & sell

Because ETFs are conveniently tradable, people tend to trade more in ETFs as compared toconventional funds. This unnecessarily pushes up the costs.

You cant automatically re-invest your dividends. Secondly, you may have to pay brokerageto reinvest dividends in ETF, whereas dividend reinvestment in MFs is automatic and with no

entry-load

Comparatively lower liquidity as the market has still not caught up on the conceptIt may, therefore, be concluded that if an investor is looking for a long-term and defensive

investment strategy in equities by backing the index rather than looking at active

management, ETF offers an alternative to index-based funds. It offers trading convenience &

probably lower costs than index funds. A case-to-case comparison is, however, important as

some index-funds may be cheaper. Also for SIPs, index-funds may prove better than ETFs.

However, in the absence of conventional MFs like in Gold, ETFs is but a natural and better

choice than buying/selling physical gold.

Commodity ETFs or ETCs

Commodity ETFs invest incommodities, such as precious metals andfutures. Among the

first commodity ETFs weregold exchange-traded funds, which have been offered in anumber of countries. The idea of a Gold ETF was first officially conceptualised

byBenchmark Asset Management Company Private Ltdin India when they filed a proposal

with theSEBIin May 2002.[23]

The first gold exchange-traded fund wasGold Bullion

Securitieslaunched on the ASX in 2003, and the firstsilver exchange-traded fundwas

iShares Silver Trust launched on the NYSE in 2006. As of November 2010 a commodity

ETF, namelySPDR Gold Shares, was the second-largest ETF by market capitalization.[24]

Exchange-traded commodities (ETCs) are investment vehicles (asset backed bonds, fully

collateralised) that track the performance of an underlying commodity index including total
http://en.wikipedia.org/wiki/Commodity_markethttp://en.wikipedia.org/wiki/Commodity_markethttp://en.wikipedia.org/wiki/Commodity_markethttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Gold_exchange-traded_fundhttp://en.wikipedia.org/wiki/Gold_exchange-traded_fundhttp://en.wikipedia.org/wiki/Gold_exchange-traded_fundhttp://en.wikipedia.org/wiki/Benchmark_Asset_Management_Company_Private_Ltdhttp://en.wikipedia.org/wiki/Benchmark_Asset_Management_Company_Private_Ltdhttp://en.wikipedia.org/wiki/Benchmark_Asset_Management_Company_Private_Ltdhttp://en.wikipedia.org/wiki/SEBIhttp://en.wikipedia.org/wiki/SEBIhttp://en.wikipedia.org/wiki/SEBIhttp://en.wikipedia.org/wiki/Exchange-traded_fund#cite_note-22http://en.wikipedia.org/wiki/Exchange-traded_fund#cite_note-22http://en.wikipedia.org/wiki/Exchange-traded_fund#cite_note-22http://en.wikipedia.org/wiki/Gold_Bullion_Securitieshttp://en.wikipedia.org/wiki/Gold_Bullion_Securitieshttp://en.wikipedia.org/wiki/Gold_Bullion_Securitieshttp://en.wikipedia.org/wiki/Gold_Bullion_Securitieshttp://en.wikipedia.org/wiki/Silver_exchange-traded_fundhttp://en.wikipedia.org/wiki/Silver_exchange-traded_fundhttp://en.wikipedia.org/wiki/Silver_exchange-traded_fundhttp://en.wikipedia.org/wiki/SPDR_Gold_Shareshttp://en.wikipedia.org/wiki/SPDR_Gold_Shareshttp://en.wikipedia.org/wiki/SPDR_Gold_Shareshttp://en.wikipedia.org/wiki/Exchange-traded_fund#cite_note-23http://en.wikipedia.org/wiki/Exchange-traded_fund#cite_note-23http://en.wikipedia.org/wiki/Exchange-traded_fund#cite_note-23http://en.wikipedia.org/wiki/Exchange-traded_fund#cite_note-23http://en.wikipedia.org/wiki/SPDR_Gold_Shareshttp://en.wikipedia.org/wiki/Silver_exchange-traded_fundhttp://en.wikipedia.org/wiki/Gold_Bullion_Securitieshttp://en.wikipedia.org/wiki/Gold_Bullion_Securitieshttp://en.wikipedia.org/wiki/Exchange-traded_fund#cite_note-22http://en.wikipedia.org/wiki/SEBIhttp://en.wikipedia.org/wiki/Benchmark_Asset_Management_Company_Private_Ltdhttp://en.wikipedia.org/wiki/Gold_exchange-traded_fundhttp://en.wikipedia.org/wiki/Futures_contracthttp://en.wikipedia.org/wiki/Commodity_market


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return indices based on a single commodity. Similar to ETFs and traded and settled exactly

like normal shares on their own dedicated segment, ETCs have market maker support with

guaranteed liquidity, enabling investors to gain exposure to commodities, on-Exchange,

during market hours.

Commodity ETFs trade just like shares, are simple and efficient and provide exposure to an

ever-increasing range of commodities and commodity indices, including energy, metals, softs

and agriculture. However, it is important for an investor to realize that there are often other

factors that affect the price of a commodity ETF that might not be immediately apparent. For

example, buyers of an oil ETF such as USO might think that as long as oil goes up, they will

profit roughly linearly. What isn't clear to the novice investor is the method by which these

funds gain exposure to their underlying commodities. In the case of many commodity funds,

they simply roll so-called front-month futures contracts from month to month. This does give

exposure to the commodity, but subjects the investor to risks involved in different prices

along the term structure, such as a high cost to roll.

Picking the Right ETF

Exchange traded funds (ETF) have caught the fancy of investors, typically due to the low cost

and recent track record of decent returns. Most of the features of ETF match with Mutual

Funds (MF) - there are however, some minor differences in terms how ETFs and Mutual

Funds function.

Before we go ahead with the discussion on How to pick the right ETF option, lets discuss

some features of Mutual Fund and ETFs.

1. ETF portfolio is a replica of any benchmark or indiceshence, any deviation in terms of

returns is adjudged as tracking error; also the transactions are limited to aligning the portfolio

with the benchmark whereas conventional mutual funds buy and sell stock based on the

market movement and fund strategy.

2. ETFs are necessarily held in demat form, while Index MFs (which are replicas of

respective benchmark)/ MFs in general can be held in physical form as well.

3. ETFs can be traded like a stock at any time of the day and at real-time prices, while the

market is open. Whereas conventional mutual funds can buy/sell at the NAV based on the

closing prices.

4. ETFs normally do not keep a large portion in cash to meet redemption pressures


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5. In conventional MFs, costs are deducted from the NAV on an average basis. Where as in

ETF each investor pays his share of costs as brokerage and thus they turnout to be relatively

more cost-efficient.

How to choose the right ETF

In India many ETFs are available with the same objective. It has become difficult to choose

the right ETF based differentiated on need and goals. India has a high number of gold

ETFs which are trading in exchanges.

Here is a guide to choose the best ETF among the list.

Asset Size

In order to consider any ETF as a viable option for investment, it should at least have a

certain minimum asset size. Anything above Rs. 50 cr should be considered a good asset size.

Anything below this threshold level lacks investor interest.

Tracking Error

The ETFs are expected to track the underlying index closely, but some ETF do not track it

closely. The ETF with minimum tracking Error should be preferred.

Liquidity

ETFs need to be checked based on the trading activity. Most of the ETFs trade heavily based

on the changes in the benchmark but few ETFs trade barely. The trading activity actually

confirms the liquidly of ETFs. The higher the trading activity, higher is the liquidity.

Diversification

The ETF should be chosen based on the diversification needed in the portfolio. An index

benchmarked ETF can be a good option for a portfolio with low exposure to equity whereas

gold ETF can work well for a portfolio that does not have any gold exposure.

ETFs again could be Debt/Equity/Gold and one could chose based on suitability to ones

overall portfolio and alignment to financial goals. Hope this brief gives you some idea on

ETF as an investment avenue.


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1. SPDR Gold ETF (GLD): This fund actually holds physical gold.2. iShares Comex Gold Trust (IAU): This ETF also holds physical gold.Gold ETFs that Own Gold Mining Stocks

1. Market Vectors Gold Mining ETF (GDX): This fund holds stocks of gold miningcompanies from around the world.

Gold ETFs that own Future Contracts

1. Powershares DB Gold Fund (DGL): This fund holds future contracts which reflect theupwards price movements of gold.

2. E-Tracs CMCI Gold Total Return ETN (UBG): This is an ETN and tracks the upwardsprice movement of gold.

ETF Double Gold

1. Proshares Ultra Gold (UGL): This fund will give you daily returns and will move doublethe price of gold in a day.

2. Powershares DB Gold Double Long ETN (DGP): This is an ETN that moves double thegold prices.

Gold Short ETFs

1. PowerShares DB Gold Short ETN (DGZ): This is an ETN that moves up when goldprices go down. So, this works like a gold short ETF where, if the price of gold moves

down by 2%, this ETN will go up by 2%

2. PowerShares DB Gold Double Short ETN (DZZ): This is also an ETN that moves updouble the amount that gold prices go down. So, if gold prices go down by 2% this fund

will move up by 4%.

ETF Gold India

1. Kotak Gold ETF (KOTAKGOLD): This is Kotaks Gold ETF that tracks the price ofGold in India. The ticker is for NSE.

2. UTI Gold ETF (GOLDSHARE): This is UTIs ETF that tracks the price of gold in India.The symbol is GOLDSHARE and is for NSE

3. Reliance Gold ETF (RELGOLD): This is the Reliance Gold ETF that tracks the price ofgold in India and the symbol RELGOLD is for NSE.

I feel that its only a matter of time when Options are introduced on ETFs in India. In fact a

few months ago there were plans to create Options on the popular Benchmark Gold BeEs

ETF on NSE, but then the FMC (Forward Markets Commission) wrote to the NSE (National
https://www.spdrs.com/product/fund.seam?ticker=GLDhttp://us.ishares.com/product_info/fund/overview/IAU.htm?c=JAC01&gclid=CIfdjo7T5ZoCFRAMDQodVFwKBAhttp://www.vaneck.com/index.cfm?cat=3192&cGroup=ETF&tkr=GDX&%20LN=3-02http://www.vaneck.com/index.cfm?cat=3192&cGroup=ETF&tkr=GDX&%20LN=3-02http://us.ishares.com/product_info/fund/overview/IAU.htm?c=JAC01&gclid=CIfdjo7T5ZoCFRAMDQodVFwKBAhttps://www.spdrs.com/product/fund.seam?ticker=GLD


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Stock Exchange) saying that they should have jurisdiction over Options trading on the

commodity based ETF since they already regulate commodities future, and this is quite

similar to that product. The launch was then stopped, and since then I havent read anything

on the matter, but I think this will happen in due course, and after that Options on other ETFs

will be launched as well.

I think that its good to have Options on these ETFs, as it allows people who are so inclined

to take positions and test out their theory.

I have no doubt that a lot of people will lose money in trading Options, but that is no different

than trading in stocks, and Im sure there will be people who make money on them as well.

It also allows you to take short positions which you cant do without Options. For example,

currently, there are no easy ways for small investors in India to take a short position in gold if

theyre so inclined but if there were Futures and Options on Gold BeES they could have sold

a Future or bought Puts.

Compare this with the US where a small investor can easily buy long dated Puts on either the

popular gold ETF GLD, or even gold mining companies like ABX, and I feel that the Indian

investor is at a disadvantage.

Options are not for everyone, but there is a segment of investors who understand these

products, can use them, and even eagerly awaiting them, and I feel that its only a matter of

time before which their wish is granted.

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