on ETFs

This was published in Money Today magazine.

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How to invest in an exchange traded fund?
August 8, 2007

Question :

I don’t like the high entry loads and expense ratios of equity funds. How can I invest in exchange traded funds (ETFs)? What is the load structure and expense ratio of an ETF? Which ETF tracks Nifty 50? How can I invest in it?

— Sumant Sarkar, Bangalore

Answer :

How to Buy: As their name suggests, ETFs are traded on stock exchanges just like any listed share. You can buy an ETF if you have a trading account with a stock broker. You also need to have a demat account.

Load Structure: ETFs have lower entry load than equity mutual funds. The brokerage payable is around 0.5% (including commission, service tax and securities transaction tax). Equity mutual funds charge 2-2.5% entry load. But there is no exit load in open-ended mutual funds. In case of ETFs, you also have to pay brokerage when you sell the units, so the total load adds up to 1%.

Index Tracking and Pricing: ETFs track a stock index and invest in shares of that index in the same proportion. They are priced at a specified fraction of that index. For instance, the Banking BeES ETF is priced at 10% of the Bank Nifty level while the Nifty Benchmark ETS is priced at 10% of the S&P CNX Nifty. If the Bank Nifty is at 6838 level, the Banking BeES will be trading around Rs 683.80 per unit. Similarly, when the Nifty is at 4,200, units of the Nifty BeES will be traduing around Rs 420 each.

Recurring Expenses: Since they invest in a fixed basket of shares and do not require active management, ETFs have a lower expense ratio—the recurring annual charge for managing the fund—of about 0.3-1%. In comparison, actively managed equity funds have expense ratios of up to 2.5%.

Index Funds: A fund type that resembles ETFs is index funds. Like ETFs, index funds have low expense ratios. These funds track stock indices and invest in the same basket of shares. The entry load is about 2.5% and the expense ratio is about 1%. But index funds do not match benchmark returns so closely as do ETFs. In fact, they often underperform the benchmark.

Equity Funds: Of course, there is always the option of investing in equity funds. Well managed equity funds usually outperform the benchmark, thus justifying their high expense ratio. But they are more volatile than ETFs and index funds. If you are willing to take a little risk for higher potential returns, diversified equity funds are a better option.

Real Time Trading: ETFs can be traded at any time during trading hours. Equity fund and index fund transactions are recorded at the end of the day.

Financial Questions I received from a friend

Publishing here if it helps other readers
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Question:

Needed a quick advice.

Ever since my EMI days, I have been slowly out of the market.

And now, I am so totally out of the market.

I just wanted to keep some money aside, and was wondering which was a better option.

Now that banks are giving a 9.5% interest rate, should I make an FD? Or should I invest in MF?

Even at 16K index, if you suggest an MF, then could you please suggest me funds and give me a breakup for investing 1L

I trust your market knowledge the best, and also got no time for any research, and hence would like to follow your advice.

Would really appreciate your time in suggesting.

Response:

this is so heartening to see young people investing for future.

The choice of investment instrument depends on your goals, risk tolerance

and risk capacity.

I read this in your email : "I just wanted to keep some money aside".

This begs the question - what for ?

I mean, what is the goal for this money ? Sounds like you would like to keep

some money as an emergency fund, which can be used in case you need money

urgently for some reason. This is a very good idea and experts say you should keep

about 6 months expenses (plus EMIs) as "emergency fund".

In case of a job loss or health problems (god forbid), this will help you.

So if that's what you have in mind, this fund should be kept in an instrument

where the risk of principal loss is minimum.

FD would be a good idea but for high tax brackets, the post-tax return sucks !

This doesn't even beat inflation. So 9.5% rate actually is not that attractive because

after tax, it is more like 6.5%.

I would consider Liquid mutual funds or variable interest rate debt funds.

They are tax efficient. The post-tax returns are better than FDs.

If you can block the fund for some period (a year or more), you can look at

FMPs. But then blocking funds earmarked for emergency doesn't make sense.

I would strongly suggest Liquid mutual funds. Opt for dividend reinvestment option.

But don't keep too much money in this emergency fund. Six months expenses plus EMIs.

Any more, and you are missing out on higher returns of other financial instruments.

Look up this site for more info on these funds.

Hope this helps.

"Even at 16K index, if you suggest an MF"

Choice of financial instruments has nothing to do with index levels.

It depends on your goals and your risk profile. I invest in equity MF every month for

my long term goals, irrespective of where index is.

Question:

Thank you for such a detailed mail.

My purpose was actually an emergency fund, which you figured so well.

Thank you for explaining how much an emergency fund should contain.

I really wasn't so sure.

I shall go over all the options that you have mentioned and then write back, for suggestions/clarifications.

"If you can block the fund for some period (a year or more), you can look at FMPs. But then blocking funds earmarked for emergency doesn't make sense."

What are FMPs?

Also If I want to start to invest monthly in MF, do you have any MF recommendations?

Response:

you are welcome !

FMPs are a special kind of bond funds.

Bond funds (also called "debt funds") are mutual funds that take money from investors like us

and lend to companies and government. Usually they don't lend directly. But they buy bond papers.

Usually debts are long term things - may be decades. To provide liquidity (so that investors can get

out if they wish to), debts are secuterized and sold in small pieces (called bond papers).

So these bonds are sold and bought in the market just like shares.

Bond funds trade in such papers and the value of these papers determines the NAV.

How FMPs are different is that they buy and hold papers for a Fixed Maturity Plan.

So they are not so volatile and the NAV doesn't swing when interest rates change.

So FMPs are safe investments in terms of volatility. They give around the same return as FDs do.

But they are much more tax efficient (for those in high tax brackets).

These should help you:

http://www.dnaindia.com/report.asp?NewsID=1001843

http://inhome.rediff.com/money/2006/dec/27spec.htm

http://www.themoneytimes.com/articles/20060715/fixed_maturity_plans_the_best_bet-id-10815.html

http://www.rediff.com/money/2006/jul/10perfin.htm

http://in.rediff.com/getahead/2005/may/16fund.htm

"Also If I want to start to invest monthly in MF, do you have any MF recommendations"

I would love to, but I have no data on your goals and risk profile to base my recommendations on.

Feel free to call me and discuss.