Unit 3: Exchange traded funds

1. Introduction to Exchange Traded Funds

An Exchange Traded Fund (ETF) is a pooled investment vehicle that tracks a specific index, sector, commodity, or other asset, but which can be bought and sold on a stock exchange exactly like a regular stock.

ETFs combine the valuation feature of a mutual fund or unit investment trust (which can be bought or sold at the end of each trading day for its net asset value) with the tradability feature of a closed-end fund (which trades throughout the trading day at prices that may be more or less than its net asset value). By offering the diversification of a mutual fund alongside the flexibility and liquidity of an equities market, ETFs have become a fundamental financial instrument for both retail and institutional investors.

2. Salient Features of Exchange Traded Funds

• Exchange Listed and Traded: Unlike traditional mutual funds, ETF units are listed on recognized stock exchanges and can be traded throughout the trading day.
• Real-Time Pricing: Their price fluctuates constantly from the moment the market opens until it closes, determined by the market forces of demand and supply.
• Trading Flexibility: Because they trade like stocks, investors can use various trading strategies such as limit orders, stop-loss orders, buying on margin, and short selling.
• Passive Management (Generally): Most ETFs are index funds designed to replicate the performance of a specific index (like the S&P 500 or Nifty 50) rather than actively picking stocks to beat the market. However, actively managed ETFs do exist.
• Transparency: ETF providers typically disclose their exact portfolio holdings on a daily basis.
• Lower Costs: The passive nature of most ETFs results in a lower expense ratio compared to actively managed mutual funds.
• No Minimum Investment via Fund House: The minimum investment is simply the price of one share (plus any broker commissions), making it highly accessible.

3. Working of Exchange Traded Funds

The lifecycle and daily operation of an ETF involve two separate markets: the Primary Market and the Secondary Market.

• Primary Market (Creation/Redemption): ETF units are not sold directly to retail investors by the fund house. Instead, the ETF sponsor (the fund manager) issues shares in large blocks known as "Creation Units" (typically ranging from 25,000 to 100,000 shares). These are transacted entirely between the sponsor and specialized institutional investors known as Authorized Participants (APs).
• Secondary Market (Exchange Trading): Once the APs receive the ETF shares, they sell them to the public on the secondary market (the stock exchange). Retail investors buy and sell ETF shares among themselves or from market makers at the prevailing market price.
• In-Kind Transactions: A unique feature of the ETF working structure is the "in-kind" exchange. APs typically do not buy creation units with cash. Instead, they buy the exact underlying basket of securities that the ETF tracks and deliver those to the sponsor in exchange for ETF shares. This prevents the ETF from having to buy and sell securities directly, significantly minimizing capital gains taxes and transaction costs for the fund.

4. Market Making by Authorised Participants (APs)

Authorised Participants (APs) are the heart of the ETF ecosystem. An AP is usually a large financial institution, broker-dealer, or market maker that has executed a legal agreement with the ETF sponsor.

Their primary role is twofold: Providing Liquidity and Price Arbitrage (Keeping the ETF price close to its NAV).

The Arbitrage Mechanism

Because ETF shares trade on an exchange, their market price can deviate from the actual Net Asset Value (NAV) of their underlying securities, creating instances where the ETF trades at a premium or a discount. APs exploit these discrepancies to make a risk-free profit, natively correcting the price in the process.

• When the ETF trades at a Premium (Market Price > NAV):

  1. The AP buys the underlying securities in the open market.
  2. The AP delivers these securities to the ETF sponsor in exchange for newly created ETF units.
  3. The AP sells these new ETF units on the open market at the premium price, capturing the profit.
  4. Result: The increased supply of ETF shares drives the ETF market price down, bringing it back in line with the NAV.

• When the ETF trades at a Discount (Market Price < NAV):

  1. The AP buys ETF shares on the open market at the discounted price.
  2. The AP delivers these "Creation Units" back to the ETF sponsor for redemption.
  3. The sponsor gives the AP the underlying securities, which the AP then sells on the open market for a higher price.
  4. Result: Buying ETF shares reduces supply, driving the ETF price up until the discount is eliminated.

5. Important Terms Related to Exchange Traded Funds

• Net Asset Value (NAV): The total value of an ETF's assets minus its liabilities, divided by the number of shares outstanding. Calculated at the end of the trading day.
• Indicative Net Asset Value (iNAV): A real-time estimate of an ETF's NAV calculated every 15 seconds during trading hours. It helps investors see an intraday estimate of the underlying basket's value.
• Tracking Error: The annualized standard deviation of the daily return differences between the ETF and its underlying benchmark. It measures how accurately the ETF mimics its index. A lower tracking error is desirable.
• Tracking Difference: The absolute difference in returns between the ETF and exactly what the index returned over a specific period.
• Creation Unit: A large block of ETF shares (usually 50,000 to 100,000) that can be bought or redeemed directly from the ETF sponsor by an AP.
• Bid-Ask Spread: The difference between the highest price a buyer is willing to pay (Bid) and the lowest price a seller is willing to accept (Ask). Highly liquid ETFs have very narrow spreads.
• Premium / Discount: When an ETF is trading at a price higher than its NAV, it is at a premium. When trading lower, it is at a discount.

6. Types of Exchange Traded Funds

The ETF universe has expanded far beyond simple broad-market equity index funds.

• Equity ETFs: Track specific stock indices. Can be broad-based (Nifty 50, S&P 500) or specific to market capitalization (Large-cap, Mid-cap, Small-cap).
• Sector / Industry ETFs: Focus on a specific sector like technology, healthcare, banking, or energy.
• Fixed-Income / Bond ETFs: Invest in government bonds, corporate bonds, state/municipal bonds, or high-yield (junk) bonds. They provide regular interest income.
• Commodity ETFs: Invest in physical commodities (like Gold ETFs or Silver ETFs) or futures contracts of commodities (like crude oil or agricultural products).
• Currency ETFs: Track the performance of a single currency or a basket of currencies against a base currency (e.g., USD, Euro, Yen).
• Smart Beta / Factor ETFs: Bridge the gap between active and passive management. They track customized indices based on specific factors like dividend yield, low volatility, momentum, or value, rather than traditional market-cap weighting.
• Leveraged and Inverse ETFs: Use financial derivatives and debt to amplify the returns of an underlying index (e.g., 2X or 3X returns), or to profit from a decline in the value of the underlying index (Inverse ETF). Highly volatile and meant for short-term trading.
• Actively Managed ETFs: Funds where a manager or a team makes decisions on the underlying portfolio allocation, rather than passively tracking an index.

7. Advantages of Exchange Traded Funds

• Diversification: A single share buys proportional ownership in dozens or hundreds of underlying securities, reducing unsystematic (company-specific) risk.
• Lower Costs: ETFs generally have lower Expense Ratios than actively managed mutual funds because they do not require an expensive team of stock analysts. Furthermore, there are no entry or exit loads.
• Liquidity: Investors can enter or exit their positions anytime during market hours, reacting instantly to market news.
• Tax Efficiency: The "in-kind" creation and redemption process means the ETF does not have to sell securities to meet redemptions, thus avoiding the triggering of capital gains taxes that are passed on to unit holders.
• Transparency: Investors always know exactly what they own because the holdings of most ETFs are published daily.
• No Cash Drag: Mutual funds must keep a certain percentage of cash on hand to meet investor redemptions. ETFs do not, meaning 100% of the funds are invested in the market at all times.

8. Comparison of Exchange Traded Funds with Other Mutual Funds

9. Applications of Exchange Traded Funds

ETFs are versatile tools utilized by retail investors, wealth managers, and large institutions to achieve various financial objectives:

1. Core-Satellite Strategy: Investors use broad-market ETFs as the "core" foundation of their portfolio to ensure low-cost market returns, while using actively managed funds or individual stocks as "satellites" to try and generate excess returns (alpha).
2. Cash Equitization: Institutional managers with large amounts of sudden cash use ETFs to quickly park that money in the market to avoid "cash drag" while they take their time researching individual stocks to buy later.
3. Portfolio Diversification: Instantly gaining exposure to asset classes that might be too expensive or difficult to buy individually (e.g., physical gold, international bonds, or emerging market equities).
4. Tactical Asset Allocation / Sector Rotation: Easily shifting investments between different sectors or asset classes depending on the economic cycle without having to buy/sell dozens of individual stocks.
5. Hedging/Risk Management: Using Inverse ETFs or shorting an existing ETF to protect a portfolio against an anticipated market downturn.
6. Arbitrage Trading: Identifying split-second pricing inefficiencies between the ETF and its underlying basket of stocks (primarily done by algorithmic traders and APs).