Exchange Traded Funds (ETF) is another category of mutual funds trying to establish its roots in the industry. As the name suggests, ETFs are listed and traded on the stock exchange, thereby offering investors a convenient mode to buy and sell mutual fund units. While ETFs have established a track record in developed markets like the US for instance, they are still finding their feet in India.

ETFs first made their presence felt in the country in 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's performance combined with a price history that was trading perpetually at discount to the NAV (net asset value), 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.

Perhaps it would have helped the investor's cause (but not Morgan Stanley's), if they had been informed that globally, close-ended ETFs usually trade at a discount to the NAV. That Morgan Stanley was the AMC (Asset Management Company) behind the launch did not make it any different. Again, perhaps greater transparency in disclosing Morgan Stanley's track record in the US, for instance, in managing close-ended ETFs would have been eye opening. In the absence of these critical inputs, it was not surprising that investors perceived the Morgan Stanley Growth Fund ETF as god's gift to the Indian investor.

When Morgan Stanley Growth Fund bombed (which is not surprising if you own hundreds of stocks, some of them duds like MS Shoes), investors got the much-needed eye opener. It upset investors so much, that they turned away from mutual funds completely for a while. Of course, as far as ETFs were concerned, they were a non-starter, if you ignore the Rs 1 bn (approximately Rs 100 crores) Morgan Stanley Growth Fund accumulated at the time of inception.

Of course, there is nothing wrong with ETFs per se. Their advantages are well documented and in some ways they hold an edge over their conventional counterparts (that are bought and redeemed at the AMC). But investors had to know the advantages to invest in ETFs. Not surprisingly, no AMC was really ambitious enough to launch an ETF. You had the regular mutual funds that were bought and redeemed by the AMC. So there was something of a lull on the ETF front.

Eight years after the Morgan Stanley fiasco came the launch of the Nifty Benchmark Exchange-Traded Fund (Nifty BeES). The Nifty BeES set the record straight for ETFs. In a way, they succeeded in establishing what Morgan Stanley with its might and expertise failed to do. Post-Nifty BeES launch, investors received critical inputs on ETFs that helped them understand the product more objectively. We have outlined some of these inputs:

1. ETFs can be close-ended (Morgan Stanley Growth Fund) or open-ended (Benchmark Nifty BeES). Being open or close-ended does not define their nature. Their nature is defined by the fact that they are traded on the stock exchange. When ETFs are open-ended they issue fresh units to investors, although this is done very selectively. The bulk of the trading is still over the exchange.

2. ETFs can be either actively or passively managed. Morgan Stanley Growth Fund is an example of an actively-managed diversified equity ETF while Benchmark Nifty BeES is a passively-managed diversified equity ETF. When ETFs are actively managed, they invest with the explicit objective to outperform the benchmark index. To that end, they are not compelled to invest in stocks from the benchmark index; they invest wherever the fund management team spots an opportunity within the broad investment mandate of the fund. When ETFs are passively managed, their stock investments are aligned to that of the benchmark index in exactly the same proportion.

3. Being exchange-traded helps both the investor and the fund manager. The investor has a more convenient mode of buying and selling mutual fund units. The fund manager is not under pressure to sell stocks in distress to meet heavy redemptions. This is because the investor never approaches the fund manager (read AMC) at all; he approaches another investor on the stock exchange.

4. ETFs when they are close-ended often trade at a discount to the NAV. This has a lot to do with the close-ended nature of the ETF. Since close-ended ETFs do not issue fresh units, the mis-pricing between the ETF price and the NAV takes the shape of a discount. The discount, at least in markets like the US, stems from the poor track record of actively managed funds in outperforming the benchmark index. Why should investors pay a premium (to the NAV) when the fund usually trails the benchmark index? The discount therefore is the investor's thumbs down to the fund's performance.

However, there are instances, although quite rare, when the ETF price is at a premium to the NAV. The shift in the ETF price from discount to premium could be due to several factors; improved fund management thereby resulting in outperformance of the benchmark index is one good reason.

When ETFs are open-ended, the reasons for discount or premium (to the NAV) are no different. When the open-ended ETF outperforms the index, there is more willingness to pay a premium.

5. In terms of expenses (including loads), ETFs hold an edge because selling and marketing expenses are relatively insignificant vis-à-vis regular funds (for whom this can account for as high as half the annual 2.50% recurring expenses). ETFs do not have a load; instead you pay a brokerage (approximately 0.50% in the Indian context) to your broker/sub-broker on each leg (buying and selling) of the transaction. However, buying an ETF gives rise to additional costs like setting up a demat account (annual charges approximately Rs 500). However, since ETF investors often also invest in stocks, the maintenance charge of the demat account is spread across stocks and ETF investments.

Since ETFs witness all the buying/selling on the exchange, the interests of the long-term investor are not compromised. Take a regular equity fund where units are bought and sold at the AMC's end  when a significant amount of money enters and exits the fund rather quickly, its the long-term investor that suffers as a result of the costs (trading costs, registrar costs, opportunity loss if the fund manager is forced to sell his best stocks) associated with this quick inflow/outflow.

With an ETF since the trading investor does not approach the AMC at all and only interacts with other investors over the exchange, his quick entry/exit does not compromise the interests of the long-term investor.

6. Unlike regular funds that can only be bought at end-of-day NAV, ETFs are bought intra-day. This is known as real time pricing since ETF investors get the price at that point in time. Real time pricing however, is usually of greater use to the trading investor; for the long term investor (with a 3-5 year investment horizon) intra-day fluctuations hold little appeal.

7. In terms of tax benefits, ETFs are no different from regular mutual funds. An equity-oriented ETF offers the same tax benefit as a regular equity fund; likewise debt ETFs and regular debt funds have similar tax benefits.
 

8. ETFs declare dividends just like regular funds. Since the dividend is ultimately declared from the NAV, the ex-dividend NAV will be lower. The ETF premium/discount will adjust accordingly to ex-dividend levels.

It is evident that ETFs have some fundamental benefits for mutual fund investors in terms of lower costs and greater convenience. Over the long-term, lower costs can add significantly to the ETF's returns. However, investors must first get over the mental block associated with ETFs and look at them with a fresh perspective.

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