Like exchange traded funds (ETFs) that they are about to launch for the first time in the country, Benchmark Mutual Fund are a new name for most investors in the mutual fund industry. So Personalfn met with Rajan Mehta, Executive Director – Benchmark Asset Management Company, to learn more about ETFs, how they work, their appeal to investors and Benchmark’s future plans.

An engineer initially, Rajan Mehta also did his masters in business management from University of Bombay and then his post-graduate diploma from London Business School. He has over 14 years experience in international and domestic financial markets. He was first a VP in DSP Merrill Lynch, Mumbai, before he was relocated to Merrill Lynch’s London office as VP – Wealth Manager.

PFN: Exchange traded funds (ETFs) are a relatively new concept in this part of the world. Can you please elaborate a little on the product, its utility, how it works and its appeal to the investor?

Mr. Mehta: ETFs are a relatively new product. They were first introduced in 1993 in the US linked to the S&P 500 by SPIDERS. The beauty of an ETF is that it combines the advantages of an open-ended fund with that of a close-ended fund. It gives investors a vehicle to participate in intra-day trading and also allows them to participate in long-term investing without paying the transaction cost of short-term investing.

Although the first ETF was launched in 1993, it only started picking up in 1996 as investors took time to understand it. Once it became popular, it hasn’t looked back since. Today, there are about 185 ETFs in the world linked to all the major indices.

As far as the working of the ETF is concerned, its structure is based on a passive fund (index fund), but it works differently. In an ETF no cash is accepted, rather they accept securities for creation and redemption. This reduces the tracking error and gives a good handle for arbitrage, which provides liquidity in the market. This allows investors to buy units through NSE terminal at very near to real time NAV (net asset value).

PFN: An ETF endeavours to combine the efficiency of an Index fund, which appeals to the serious investor with real time quotes, which appeal to the stock punter. There is a possibility (and its happened abroad) that it may finally end up as another outlet for punting and overshadow the long-term goals of the product as an index fund. Your comments…

Mr. Mehta: The beauty of the product is that it appeals to a large variety of investors. In the US, it is used for punting as well as for long term investing. A lot of pension funds have ETFs as the core portfolio. At the same time, there are others who invest in it for day trading. So the product serves varying investment objectives. It appeals to investors, big and small, it fulfills short term and long-term goals and both institutional investors and retail investors can participate in it.

PFN: As far as long term investing is concerned, how are ETFs different from conventional index funds?

Mr. Mehta: As you are aware index funds have two important factors - costs and tracking error that determine its efficiency. An ETF scores over conventional index funds on both these counts. There is also a convenience factor with ETFs as all units are in demat form and the investor can use his existing demat account. No forms need to be filled. The investor simply needs to contact his broker or buy through an online broker.

Now lets look at the two traditional factors that are important to an index fund – cost and tracking error. As far as costs go, at 80 basis points, we have one of the lowest costs in the country, even lower than some liquid funds. Most index funds have an expense ratio of 2.0-2.5%. So the difference between the two is about 120 basis points. Over 15 years, with compounding, the difference can be significant. In addition to this, conventional index funds have hidden costs. For instance, if the fund gets fresh subscriptions, the fund manager has to buy these stocks. This will add to the trading costs and this is borne largely by the long-term investor. With ETFs this is not the case, as there is in-kind creation and in-kind exemption.

Even the tracking error is lower with ETFs vis-à-vis index funds. Index funds buy stocks during the day but units are allotted at end of day NAVs, which gives rise to the tracking error. Moreover, index funds have to keep some amount in cash to meet redemptions, which adds to the tracking error.

PFN: What is the minimum investment for an ETF?

Mr. Mehta: The minimum investment is 1/10th of the S&P CNX Nifty. So if the Nifty is 1,050 points today, the minimum investment is Rs 105 per unit and in multiples thereof. And the investor can buy just one unit with the demat facility.

PFN: There is obviously a learning process with ETFs (exchange-traded funds). How do you plan to popularize the product with investors so as to evoke interest?

Mr. Mehta: With ETFs, there is a learning process at two levels. One is about indexing and how it can be a good investment avenue. We will join the process of creating more awareness for indexing. The other learning process relates to the structure of the fund. This is a one-time process. Once we have accomplished that, for the subsequent product offerings, we need not repeat the same thing. .

PFN: This is Benchmark’s maiden foray in mutual funds. Given that you are relatively unknown to the mutual fund investing community, how do you propose to establish your name?

Mr. Mehta: Establishing one’s name is important in the mutual fund industry. Its important to know who are the sponsors, their track record, experience in fund management. This is more relevant for active fund management, rather than passive fund management. We are going to deal in passively managed products. The prospectus will define what companies we will be investing in and we will stick to that. As far as our integrity is concerned, we know that the mutual fund has a Board of Trustees who are the supervisors of the mutual fund . On our Board of Trustees we have some very eminent personalities. Dr S. A. Dave is the chairman of our Board – ex-chairman of SEBI and UTI. We also have professionals in the fields of accountancy, law and academics giving our board a well-rounded look. If you look at SEBI’s compliance regulations, they are amongst the best in the world. And SEBI has made the Board of Trustees responsible for ensuring that the mutual fund abides by the provisions of the offer document. So if you have credible trustees, it gives lends a credible look to the mutual fund.

PFN: What other passively managed products do you have on the anvil?

Mr. Mehta: We are looking at ETFs of other indices.

PFN: How many ETFs can you possibly have linked to one index? What is the trend abroad?

Mr. Mehta: Typically, there is one ETF linked to one index. You have several conventional index funds linked to one index, because each fund has its own set of distributors and investors, which it would like to target. But with an ETF that is not the case, so there is no scope for another player. The scope for other players to innovate is very limited. Moreover, ETFs are thinly priced so the margins aren’t attractive enough to make others enter into the field.

PFN: What is stopping other domestic fund houses like an Alliance Capital Mutual Fund or a Franklin Templeton from launching an ETF? For instance, in the US, did Vanguard – a well-known name in index funds, try launching an ETF?

Mr. Mehta: Initially, Vanguard resisted the idea. But when they saw the popularity of SPIDERS, they launched their own version called VIPERS . But as I have said, once the first player launches an ETF, it is difficult for the second player (linked to the same index) to grab market share and even more difficult for the third player.

Besides, launching an ETF requires a different set of technical skills and is not as easy as it may appear. It requires a different marketing approach and different systems vis-à-vis traditional mutual fund products. The other fund houses have a different agent network most of which do not have a NSE terminal. Most of their investors may not have a depository account. So these fund houses have a different model altogether.

PFN: Being new to the industry, have you tied up with an international ETF?

Mr. Mehta: No we haven’t tied up with anyone. We have been studying ETFs for the last two and a half years and went ahead on our own.

PFN: What kind of books do you like to read?

Mr. Mehta: Apart from books on finance, I like to read books on spiritual topics.

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