Investment Opportunities in India

January 28, 2013

June 21, 2011

Investments in Exchange Traded Funds

Exchange traded funds are a combination of mutual funds and stocks in the sense that they follow a specified index like the former and traded in stock exchange like the latter. Investments in gold or real estate which are not conventional forms of mutual funds could be routed as ETFs. Exchange traded funds fluctuate according to an index which is unlike a non-indexed commodity like stocks.

Normal mutual funds are traded directly by AMCs (asset management companies). Money collected from investors creates a corpus which a fund manager uses to build an appropriate portfolio. For redemption of units certain portion of this corpus is sold. Traditional MFs (mutual funds) behave this way and are termed ‘in-cash’ units. In contrast, for ETFs all shares comprising an index are deposited with AMCs against creation units. As creating these ‘units’ involves deposition of underlying gold or shares these are ‘in kind’ in nature.

These large creation units are broken into small portions and traded in the stock market by authorized participants. As such, unlike a traditional MF where the corpus changes every time it is traded, for an ETF this remains intact. If however, the demand for ETF is high, more share deposition is done by authorized representatives with the concerned AMC for creating more units. Likewise for redemptions, these representatives take their shares back, sell them and pay investors.

Features of Exchange Traded Funds as against Mutual Funds
ETFs are always index specific and need certain named share deposition for creating units. Being index specific the portfolio remains unchanged as compared to a mutual fund where it might change daily. Also, ETF portfolio could be judged in advance as against MF which is known only at monthly disclosures.

ETF are traded in the stock market though a demat account as against mutual funds which are traded thorough asset management companies. Unlike mutual funds which are traded on net asset value (NAV) based on closing price, ETFs are traded at real time prices any point of the day. ETFs behave as open ended investments in the sense that unit capital changes with trading. In comparison, unit capital of MFs or stocks remains unchanged with trading or is close ended.

Investments in ETFs though safe are subject to market risks. For these investments large amounts of cash for redemptions are not required to be involved by asset management companies. Further, stocks need not be sold to meet cash redemptions unless the volume is too large. Normal trading of stocks is sufficient to manage regular redemptions. An investor in ETF only pays towards his share as compared to a MF investor whose cost is deducted from net asset value.

Benefits of Exchange Traded Funds
ETFs could be traded anytime of the day in stock exchanges in real time prices. It is possible to even trade one unit or make margin purchases of ETFs, unlike normal MFs where it is impossible. ETFs investments like all index funds are transparent and free from ambiguity. These investments are independent of fund managers’ involvement. These are passively regulated with low administrative and distribution costs.

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