Expense ratio for ETFs is lower than MF

Exchange-traded funds (ETFs) are, in the opinion of many market experts, an idea whose time has come. Global investors are affirming this belief by pouring huge sums into these products. As of December 31, 2010, the global assets of ETFs of all hues amounted to a staggering $1.48 trillion, an impressive jump of 28% year-on-year.

Today, the ETF industry encompasses products across the entire spectrum, be it equities, fixed income, commodities, currencies, etc. They are also the preferred vehicle of many institutional investors as they provide an easy way to take (onshore or offshore) exposure to certain geographies or products, which otherwise may have been inaccessible.

In India, however, ETFs are yet to catch investors’ fancy in a big way. This may probably be due to the perception that they are difficult to understand or maybe because they have not been marketed very aggressively.

Here’s a quick lowdown on ETFs:

Equity ETFs are unitised products that closely resemble index funds. However, they are listed and traded on exchanges. They are akin to baskets that reflect the composition of an index, like the S&P CNX Nifty or the BSE Sensex. Globally, they have proved to track the underlying more closely than index funds have. In other words, they have lower “tracking error”.

Their trading value is based on the net asset value (NAV) of the underlying constituents it represents. Their NAV changes on a real-time basis and the market price per unit tracks this NAV closely.

The expense ratio for ETFs is usually lower than any mutual fund. This adds to investor returns over the longer term. However, since these units are purchased through a stockbrokers, brokerage has to be paid.

There is no market making by the mutual fund that launches the ETF. Designated market makers provide the liquidity. These entities are able to do so due to a process known as the “in-kind creation/redemption process”, which enables them to convert the underlying shares into units and vice-versa.

Some of the globally renowned ETFs include the SPDRs (based on the US S&P 500 Index), QQQs (based on the NASDAQ 100) and the SPDR Gold Trust (the world’s largest gold ETF). A few well known Indian ETFs include the Benchmark Nifty BeES, Benchmark Gold BeES, Kotak PSU Bank ETF and the Motilal Oswal NASDAQ 100 ETF.

Who should invest in ETFs?

I would not consider ETFs as an asset class or an investment strategy. They are merely low-cost vehicles to take exposure to a particular asset. Hence, they are suitable for all types of investors. Some shun ETFs thinking that they are suitable only for traders. That is not entirely correct. Although some brokers position them as market-timing vehicles, the low expense ratio and low tracking error of ETFs actually helps long-term investors too.

Also, it may be more convenient to take exposure to a certain asset (such as fixed income or commodities) through an ETF. Among Indian ETFs, gold ETFs have a disproportionate share of over 90% of the total assets under management. Again this may be due to the fact that while one can trade in individual scrips as easily as in an equity ETF, gold ETFs offer a truly superior vehicle compared with physical purchases. There are silver and fixed-income ETFs on the anvil too.
What are the advantages of investing through ETFs?

Considering that they encompass most mainstream asset classes, investors have an opportunity to achieve their desired asset allocation in a cost-effective and uncomplicated manner through ETFs.

Certain ETFs like liquid ETFs help investors earn higher returns on their idle cash balances.

Sophisticated investors can hedge their portfolio risk by short-selling ETFs (though this is not possible in India so far). The smaller denominations in which ETFs trade relative to most derivative contracts provides a more accurate risk exposure match, particularly for small investment portfolios.

ETFs are not tax unfriendly as the rules that apply to the underlying asset apply to ETFs too.

Unlike an open-ended fund, outsized redemptions by large or short-term oriented investors do not harm the interests of long-term investors as the “in-kind” process mentioned above ensures that the impact cost of such redemptions is minimal.

This article appeared on The Financial Express on June 28 2011.

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