Intelligent Investor

The past few weeks have been a complete nightmare for traders and investors alike across the globe due to the fear of an impending recession on the back of the sub-prime crisis in the US. Equity markets across the world collapsed in tandem with every new trading day bringing in more gloom for all. While most investors took heavy losses, some savvy investors were quick to jump into the market on the announcement of the fed rate cut in the US and ride the pull-back-rally. Again while equities suffered worldwide, gold and bond prices have been sky-rocketing at the same time. Hence markets offer opportunities to investors even in periods of gloom.

An excellent investment avenue for market savvy mutual fund investors is an Exchange Traded Fund. Exchange traded funds (ETF), as name suggest, are mutual funds that are listed and traded on the stock exchanges on a real time basis. An ETF can have any underlying asset class like equity or debt or bullion. Investors with a demat account and a trading account can buy and sell the units of an ETF through a registered broker on the stock exchanges just like equity stocks. Investors can track these funds daily on a live basis and take advantage of price movements due to market dynamics. Thus, an ETF is a cross between a regular mutual fund and any other market traded instrument like equity or gold.

ETF are generally similar to index funds and follow a passive investment style. In other words, the portfolio composition of these funds adhere to its respective index. Thus, when an investor buys an ETF that follows Nifty the each unit of the ETF will comprise of all the shares in the Nifty in the same proportion. Accordingly, the value of the particular ETF will move in tandem with the prices of the shares. For e.g. if an investor bought a nifty exchange traded fund when nifty was at 4500 and sold it at 4950, then his returns would be 10%, thus commensurate to the change in nifty. Similarly a gold ETF is benchmarked against the London Metal Exchange (LME) price of gold and moves in tandem with the LME gold prices.

One of the major advantages of ETFs is trading flexibility over regular mutual funds. As ETF are traded on the stock exchanges they can be bought and sold at desired throughout the trading day unlike a regular mutual fund. On the other hand, in the case of regular mutual funds investors have to buy or redeem units on the closing daily Net Asset Value (NAV). Thus ETFs offer investors the convenience of intra-day sale and purchase of mutual fund units, which is not possible in regular mutual funds. Now imagine if investors were able to buy ETFs when equity markets hit the 10% down circuit recently and closed down for an hour after which they recovered substantially, then they would have seen immediate gains. On the other hand, investor’s regular open-ended fund would have got the pricing based on the losing prices of the day thus depriving them of the intra-day movements.

One of the drawbacks of regular open ended mutual funds is they suffer redemption pressures. Accordingly, to meet the liquidity requirements, fund managers are often forced to sell their best stocks or keep a good part of the fund’s portfolio in cash. In abnormal situations of large redemptions, this could, sometimes, jeopardize returns potential for long term investors. ETFs on the other hand do not have this problem. One obvious problem faced by investors in ETFs is of tracking error. Tracking error relates to the change in the ETF performance relative to its benchmark like Nifty or Sensex or old prices. In simple words, ETFs cannot exactly match the performance of their benchmark for a variety of reasons including corporate actions like rights, bonus, dividend etc. Tracking error also occurs when some of the port folio stocks suffer abnormal swings and cannot be bought or sold for a variety of reasons including volatile market movements. A low tracking error signifies an efficient fund. Expense is another area where ETFs score over regular mutual funds. While an investor in regular mutual funds is subjected to entry load of 2.255, no such impositions are applicable while trading in ETFs on local bourses. Instead, investors in ETFs pay the brokerage similar to equity shares that thy pay to their respective brokers.

The expense ratio of ETFs is generally lower as compared to regular mutual funds. Expense ratio represents the fund’s operating expenses expressed as a percentage of average value of fund’s assets under management. The Expenses ratio for ETFs on an average is 0.76% while the average expense ratio of regular equity diversified funds on an average is over 2%.

However, ETFs too have their share of drawbacks. Firstly, ETFs are not very popular and the respective funds have to arrange market makers to provide the purchase and sales in such funds. This considerably restricts the liquidity in ETFs especially during volatile times. Secondly, ETFs are a new concept and yet to pick up in terms of demand or market visibility especially from the retail angle. Some of the ETFs in the market linked to either Nifty or Sensex or those ones related to bank stocks are used mainly by institutional investors like banks, corporate companies and FIIs remain largely in the institutional domain. The introduction of gold ETFs has spurred good retail interest of late and there have been healthy sales to retail investors.

ETFs are a vehicle for the very savvy investors. Most retail investors do not understand the markets well nor do they have the wherewithal to study ad time the market to perfection. Retail investors would do well to steer clear of ETFs especially the equity ones if their investment decision is not based on thorough research and analysis. They can selectively invest in gold ETFs if they understand gold industry dynamics and pricing well.