Where an exchange traded fund scores over an index fund is perhaps in its amenability to intra-day trading on the bourses.

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Exchange traded funds (ETFs) are such a rage in the US that they account for around 60 per cent of the stock market volumes. In India, on the other hand, ETFs have been a damp squib with hardly five or six funds around.

The failure of ETFs to take off in a big way can be linked to and explained by the fact that its precursor, that is, Index funds themselves have not aroused any significant investor interest in the country.

How index funds work

Index funds originated in the West in response to the felt need to do away with fund managers and their expensive research teams. They function almost robotically by duly following the index they swear by. Thus an index fund based on Bombay stock exchanges bellwether index Sensex would simply buy or sell the shares comprised in the Sensex basket in tune with the fluctuations in the index so that at the end of the day its portfolio reflects faithfully in terms of resource allocation the weight assigned to each scrip contained in the basket.

Perhaps, an average Indian investor in mutual funds abhors this kind of passivity on the part of mutual funds and instead plumps for funds that outperform the index by proactively participating in the market. Be that as it may.

ETF is basically an index fund with accoutrements of a close-ended fund thrown in for good measure. In an index fund there is a New Funds Offer (NFO) that kicks off the operations of the fund. But not so in the case of an ETF.

ETF mechanics

An ETF instead invites shares strictly belonging to the index it is going to be fashioned after from Authorised Participants (APs), read big-ticket investment houses. Thus a Sensex-based ETF would invite for deposit all the 30 scrips comprised in the Sensex basket and in return issue the APs creation units which, like a vanilla unit of a mutual fund, represent the underlying shares.

The APs then become the market makers and offer a two-way quote in the stock exchange where these are traded as shares. What do all these boil down to? Well, the APs have now a diversified portfolio sans any cash outgo for the shares they didnt posses in the first place.

In a way they have entered into a barter type of arrangement with the mutual fund playing the role of an intermediary.

In the stock exchange when one buys these master shares, as it were, one is actually buying all the shares comprised in the Sensex, thus allowing one to profit through diversification which in any case is the hallmark of any mutual fund scheme.

The role of the Asset Management Company (AMC), as noted earlier, is passive and almost robotic in the context of an index fund. Well, in the context of ETF it is even more passive, cashless as it is virtually and supplanted as it is by the APs.

The APs can at any time redeem their units and get back the shares they had deposited from the AMC but not the players in the market who have normally only one exit route through the APs who profit from the spread between the two-way quotes.

Dual characteristics

An ETF then is a hermaphrodite having the trappings of a unit as well as a share.

It is a share inasmuch as it is quoted on the bourses which incidentally also vest it with the trappings of a unit of a close-ended scheme. It is a unit as well because its underlying assets are the shares comprised in an index it tracks.

That ETF gives the APs best of both the worlds diversification with the option to pull the chestnut out of fire whenever the other scrips weigh down on what they brought to the table but not to the lesser mortals coupled with its innate confusing duality is perhaps what makes the product unappetising for Indians. But its heightened popularity, especially in the US, naturally must have something to commend itself.

It certainly cannot be novelty alone which in any case wears off sooner than later. A deeper examination shows that unlike a vanilla mutual fund scheme where the fund manager enjoys a greater leeway in his choice of investments and disinvestments, an ETF ties down a funds manager almost to passivity, thereby forcing him to train his guns strictly on the index it is tied to.

Perhaps this brings a sharper focus to the scheme which incidentally is also the feature of an index fund.

Where an ETF scores over an index fund is perhaps in its amenability to intra-day trading on the bourses unlike in an open-ended index fund where one has to wait for the day to be over so as to buy/redeem the units at NAV. In short, ETF is a product that is perceived to be catering more to the interests of APs, the big-ticket players

S. Murlidharan
(The author is a Delhi-based chartered accountant.)