Investors can look at two vehicles for their passive investment i.e. Index Funds and Exchange Traded Funds.
First Index Fund (available for general public for investment) was launched by John Bogle in 1975. At that time, it was heavily derided by competitors as being “un-American” and the fund itself was seen as “Bogle’s folly”. Bogle’s fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor’s 500 Index. It started with comparatively meagre assets of $11 million but crossed the $100 billion milestone in November 1999. In India first Index Fund was launched in 1999.
The second option of Exchange Traded Funds (ETFs) had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes.
~: Comparison of Index Funds and ETFs :~
~: Exchange Traded Funds :~
Operationally, Index Funds works exactly like a traditional mutual fund schemes. On the other hand, ETFs are mutual funds which acts like a stocks and are traded on the secondary market of stock exchanges
In this section, we will try to debug intricacies of ETFs.
- NAV Pricing
Unlike traditional mutual funds, where investment is made based on end of the day Net Asset Value (NAV), in case of ETFs, investment is made based on real-time NAV.
Generally, ETFs are priced at 1/10th or 1/100th of respective Index known as index tracking ratio.
Let us consider an example where Nifty 50 based ETF is priced at 1/10th of an Index.
In such case, if Nifty 50 index value is 8,000 points, NAV of an ETF will be Rs. 800. If Nifty index go up to 9,000 point, NAV of ETF will rise to Rs. 900 and if Nifty index go down to 7,000 point, NAV will also move down to Rs. 700.
However, NAV of an ETF will not exactly match the tracking ratio. This is mainly due to dividend received from underlying stocks and expenses charged to the scheme.
E.g. if index tracking ratio is 1/10th, and index level is at 8,000 points, NAV of an ETF should be at Rs. 800. Assuming there is no change in the index level for next one year, and scheme is charging 0.50% as annual expense ratio, and have got the overall 1% of dividend which is reinvested. In such case, after a year, instead of NAV remain at Rs. 800, it will go up to Rs. 803.96 i.e. Rs. 800 + 1% of dividend reinvestment ( i.e. Rs. 8) and deduction of 0.50% of expenses (i.e. Rs. 4.04 on reinvested amount)
Many ETF providers, distribute dividends when there is substantial gap between price index and NAV of an ETF. In above example, ETF provider may distribute per unit dividend Rs. 3.96 to align the NAV with underlying index.
In case of traditional index funds, investors can directly buy or sell units with AMCs / Fund House in small denomination.
There are two ways of investing in ETFs, i.e. on stock exchange and directly through manufacturers (i.e. AMCs / Fund Houses)
As an investor you may buy or sell ETFs on secondary market of stock exchanges where ETFs are listed. On stock exchange, investors quote their prices and create demand and supply. Investors can buy and sell even single units of ETFs on the exchanges.
Let us assume the current NAV of an ETF is Rs. 100 per unit. Depending upon popularity of an ETF & demand / supply of units, trading price of an ETF should ideally be in the range of Rs. 99.50 to Rs. 100.50 per unit i.e. +/- 0.50%.
However, if a particular ETF is not so popular and there are very few buyers or seller in the secondary market, in such case, if there is large buy order, price of an ETF may go up to Rs. 110 / 115 per unit and if there is large sell order price of an ETF may go down to Rs. 85 / 90 per unit.
To avoid such issues ETF manufactures appoints “Authorised Participants (APs)“. Job of an AP is to maintain the liquidity of ETF units and manage demand and supply on the exchanges. As soon as trading price of an ETF breaches particular range in relation to its real-time NAV, APs start providing liquidity on both buy and sell sides. Due to this mechanism trading prices of ETFs remain close to their real-time NAV.
Let us understand how it works.
Let us assume, NAV of an ETF is Rs. 100. Like a shares, there are 5,000 units which are available for trade on the exchange. In such case, the asset under management (AUM) of this ETF is Rs. 5 Lakhs (5,000 units x Rs. 100 per units).
These 5,000 units will keep on trading at around Rs. 100.50 and Rs. 99.50 i.e. if someone wants to buy ETF units there are sellers who are willing to sell units at a premium of up to 0.50% and if someone wants to sell, there are buyers who are willing to buy at a discount of up to 0.50%, in relation to it’s NAV at that point of time.
Now there is an investor who wants to buy 10,000 units. In normal situation, trading price of this ETF will shoot up. Here, Authorised Participants, come in to action as they see the arbitrage opportunity, and they will start selling unit and provide the liquidity. Simultaneously, APs will approach ETF manufacturer i.e. an AMC / Fund House, which will create new ETF units on real-time basis and supply it to APs.
These APs are secondary market stock brokers, appointed by AMCs / Fund Houses. They have an understanding with AMCs that they should charge up to the transaction cost and small % of profit for providing liquidity and maintaining unit inventory with them.
As AMCs / Fund Houses are able to create or redeem ETF units on real-time basis, and APs keep an eye on market depth and liquidity of ETFs, trading price of ETFs generally do not breach there price range in relation to its NAV.
For providing liquidity APs has to maintain inventory of ETF units with them. They charge small % (0.50% in this example) on real-time NAV of ETFs and keep revising their buy / sell quotes as per price movements of underlying index. This small charges are to cover their transaction costs, funding cost for maintaining unit inventory and very small arbitrage profit.
Investors can also directly approach ETF manufactures for creating / buying and redeeming / selling ETF units. However, transactions directly with AMCs / Fund Houses has to be in multiple of lot size defined by them. E.g. if AMC have defined lot size as 5,000 units and if the NAV of an ETF is Rs. 1,000 per unit, in such case, transactions directly with fund house has to be in multiple of Rs. 50 Lakhs.
- Creation Size
Investor can buy or sell ETF units on the stock exchanges in multiple of 1 unit. However, in case if any investor wants to buy or sell ETF units, directly with AMCs / Fund House, the minimum application size is mentioned in “Creation Size”
To efficiently track the underlying index, ETF scheme has to buy basket of stocks in same proportion as defined by that index.
Suppose, investor wants to invest Rs. 100 in an ETF.
This ETF is tracking an index which has three stocks. Stock A has weight of 50%, Stock B has weight of 25% and stock C has weight of 25%.
In such case, Rs. 50 will be allocated to stock A, Rs. 25 to stock B and Rs. 25 to stock C.
Now suppose, market price of stock A is Rs. 10, stock B is Rs. 25 and stock C is Rs. 50. In such case this ETF scheme will buy, 5 shares of stock A (Rs. 50 ÷ Rs. 10 per share), 1 share of stock B (Rs. 25 ÷ Rs. 25 per share) but buying of stock C will not be possible as Rs. 25 has to be allocated to stock C and the price is Rs. 50.
In such case ETF scheme will increase the minimum investment amount to Rs. 200 so it can buy at least 1 share of stock C.
In this example, if investor wants to transact directly with AMC / Fund House, s/he has to do transactions in multiple of Rs. 200. Further, if NAV of this ETF is Rs. 25 per share, the unit creation size will be 8 units (Rs. 200 of investment amount ÷ NAV of Rs. 25 per share).
In other words, if investor wants to directly transact with ETF manufacturer, instead of buying or selling ETF units on secondary market of stock exchange, it has to be in multiple of “Unit Creation Size” of 8 units per lot.
Normally, Unit Creation Size is defined by the AMCs at the time of launching. Even if AMC has the discretion to change the size as and when required, it is not revised frequently.
Investors buying or selling ETF units on stock exchanges need NOT to worry about unit creation size, as on exchanges they can trade in multiple of 1 unit.
- Cash Component
Note: Investor investing through stock exchanges, need not to worry about cash component. Cash component comes in to picture only while buying or selling ETF units directly with AMCs.
Cash component is the rounding off difference, incurred while allocating investment money to the index. It is also generated due to accumulation of dividend and cash lying in the ETF scheme.
Let us understand this with an example. Suppose, unit creation size of an ETF is 100 unit per lot and the NAV of this ETF is Rs. 10. In such case, ETF scheme has to make the total allocation of Rs. 1000 (100 units x Rs. 10 per unit) in underlying index.
Assuming, index contains 3 stocks. Stock A has weight of 50%, stock B has weight of 25% and stock C has weight of 25%. Per share price of Stock A is Rs. 128, stock B is Rs. 196 and stock C is Rs. 45
Here, out of Rs. 1000, Rs. 500 has to be allocated to stock A, Rs. 250 to stock B and Rs. 250 to Stock C as per weight of these stocks in Index.
Ideally, ETF scheme should buy 3.91 shares of stock A, i.e. Rs. 500 / Rs. 128 per share. However, we can buy either 3 shares or 4 shares. In this case ETF scheme will buy 4 shares of stocks A, and instead of allocating Rs. 500 to stock A, Rs. 512 (4 shares x Rs. 128 per share) will be allocated. Like wise in stock B, Rs. 196 will be invested and in stock C Rs. 270 will be invested. Total of such investment will be Rs. 978 i.e. Rs. 512 + Rs. 196 + Rs. 270 against Rs. 1000. This difference of Rs. 22 is collected from the investor as “Cash Component” and kept in the fund.
Investors who are investing in ETF through stock exchange need not to worry about this as this is already factored in the NAV. Investors who are directly buying / selling ETF units through the AMC / Fund House, need to pay this amount. Cash component is not an expense for the investors but is the part of their investment.