[Submitted by CA. Vibhuti Gupta,
Chartered Accountant,
New Delhi]

April 1, 2008

Exchange Traded Funds (ETF) is defined as a security that tracks an index, a commodity or a basket of assets like an index fund but trades like a stock on an exchange and experiences price changes throughout the day as it is bought and sold. ETF were first launched in 1993 in United States. Their popularity as a structured product has grown immensely because of the benefits it provides to investors and traders. The issuance of EFT is just like a primary market IPO or a mutual Fund NFO. Shares are issued by the Fund manager and listed on the exchanges. Investors can buy and sell these shares from the secondary market through their brokers. ETF are often called as index shares, are a hybrid of index

The advantages of a Traded fund shares are :

  • Tradable and diversifiable: ETF offer a unique advantage as they are diversifiable like mutual funds and also can be traded like stocks. Mutual funds cannot be traded each day like a stock
     
  • Low cost: ETF like an Index fund does not require active fund managed and is therefore cheaper as passively managed.
     
  • Transparency: ETF is a very transparent instrument, as everyone knows the underlying asset.
     
  • Makes multiple trading strategies possible: Arbitrage opportunities between cash and futures market can be availed at low cost. Trading strategies can be applied
    with stop loss orders.

The disadvantages are:

  • Broker and commission costs: ETF are traded through brokers and hence every time brokerage has to be paid which becomes costly affair if regular trades are done.
     
  • Premiums and discounts: An ETF might trade at a discount to the underlying shares. This means that although the shares might be doing very well on the bourses, yet the ETF might be traded at less than the market value of these stocks.
     

Difference between ETF & Mutual Funds :

ETF Comparison - While similar to an index mutual fund, ETFs differ from mutual funds in significant ways.

Attribute ETF Index Mutual Fund Individual Stock
Diversification Yes Yes No
Traded throughout the day Yes No Yes
Can be bought on margin Yes No Yes
Can be sold short Yes No Yes
Tracks an index or sector Yes Yes No
Tax efficient as turnover is low Yes Possibly No
Low Expense Ratio Yes Sometimes Not a factor
Trade at any brokerage firm Yes No Yes

Gold ETFs

In a gold crazy country like India, Gold ETF is sure has the potential to emerge as a popular investment product. A gold-exchange traded fund unit is like a mutual fund unit backed by gold as the underlying asset and would be held mostly in demat form. An investor would get a securities certificate issued by the mutual fund running the Gold-ETF defining the ownership of a particular amount of gold. GETFs are designed to offer investors a means of participating in the gold bullion market without the necessity of taking physical delivery of gold, and to buy and sell through trading of a security on a stock exchange.

With gold being one of the important asset classes, GETFs will provide a better, simpler and affordable method of investing as compared to other investment methods like bullion, gold coins, gold futures, or jewellery.

India currently has five gold Exchange Traded Funds listed on the National Stock Exchange, including Reliance Gold Exchange Traded Fund, Gold Benchmark BeEs, UTI Gold Exchange Traded Fund, Kotak Gold ETF and Quantum Gold Fund.

Advantages of GETFs

  • No risk of holding physical stock: As GETFs are issued in demat form, the risk associated with holding physical gold is reduced considerably.
     
  • Affordable: GETFs are ideal for small retain investors as they can buy a just one unit from the exchange. The minimum amount of investment during the NFO period for Cash is Rs 10,000 and in multiples of Rs 1,000 thereafter. One unit of the fund will represent one gram of gold.
     
  • High Liquidity: GETFs can be easily bought / sold like any other stock on the exchange during market hours at real-time prices as opposed to end of day prices.
     
  • Lower cost: GETFs enjoy the benefits of lower cost and higher transparency. As they are listed on the exchange, costs of distribution are much lower. Further, exchange traded mechanism helps reduce minimal collection, disbursement and other processing charges. Gold futures include the cost of carry that will be absent on a GETF.
     
  • Low tracking error: Tracking Error of GETFs is likely to be low as compared to a normal fund. Due to the creation / redemption of units only through in-kind mechanism the fund can keep lesser funds in cash. Also, time lag between buying / selling units and the underlying physical gold is much lower.