ETF- Exchange Traded Funds or Exotic Traded Funds??? A Boon or a Bane??

Authors : Roy Paul  Mathew  , SJMSOM-IIT BOMBAY
              Bindiya Bansal , SITM 

Exchange traded funds, a low-cost form of investment which has immense popularity among retail investors, is becoming an increased source of fear of it being the source in waiting for a systemic institutional risk which can in turn lead to a Financial Scandal. This article analyses the functioning of ETF, its advantages and disadvantages and the growing concern of whether ETF can be a source of pollution instead of revolution by attaching too much risks by complicating a simple idea.

What is ETF?

ETFs are part fund, part stock passively managed schemes that invest their entire corpus in a basket of securities, such as equity shares. Think of an exchange-traded fund as a mutual fund that trades like a stock and reflect an index such as Nifty. An ETF, however, isn't a mutual fund; it trades justlike any other company on a stock exchange. Unlike a mutual fund that has its net-asset value (NAV) calculated at the end of each trading day, an ETF's price changes throughout the day, fluctuating with supply and demand. ETFs attempt to replicate the return on indexes; there is no guarantee that they will do so exactly.ETF doesn’t aim to outperform their Benchmark indices but rather follows passive tracking.ETFs first hit the market in 1990 and Some of the popular ETFs are Spider(SPDR trading under symbol SPY) which tracks the S&P 500 index and examples of ETF providers are  Barclays Global Investors (BGI) and State Street. ETFs can be basically of 2 types

    1)    Leveraged ETFs  

Leveraged ETFs offers a geared return on a given index.

     2)    Inverse ETFs

Inverse ETFs aims to go down when the bench mark goes up 

A view on the performance of ETFs

                                   

Advantages of an ETF

     1)    Automated Mechanism

ETF’s work on an automated mechanism and basically can be employed by investors who wants to avoid the fund manager. Hence ETFs are better products with more features for a lesser amount of money. ETFs are listed in stock exchanges which enables investors buying and selling and unlike conventional MF’s, ETFs can be traded all day long.

      2)    Diversification coupled with flexibility of a stock

      An ETF gives the advantage of diversifying an index fund. Since ETF’s trade like stocks, an investor can short sell them, buy on margin and even purchase a single share.It leads to financial democratisation, since small or big investors can trade on same terms. Nowadays ETFs which tracks private equity, vaccine stocks, clean energy, gold and much more available apart from the regular bets on standard indexes.

    3)    Lower Expense Ratio compared to Mutual Fund

Since cost of active tracking by fund managers is nullified by its automated mechanism, while buying and selling ETFs, the broker is getting paid the same commission as for a normal regular trade. It allows investors to get “beta” (market returns) on the cheap, while MF’s strive hard to achieve “alpha” (extra returns through skill), charging more for the privilege.

  

     4)    Greater Tax Efficiency and Liquidity

Since ETF units can be created and dissolved against a basket of shares, there is a constant cash component. Since the responsibility to create ETF units rests with the market maker, they don’t have to pay brokerages to stock brokers since ETF does not buy or sell securities in the market.

How does an ETF work?

The market makers in the stock market are appointed by fund house who are entrusted with the responsibility of buying the basket of securities (e.g. market index scrips) and pass it on to the fund house in exchange for a certain number of units. This process is called as “Unit Creation” .The market maker splits these units and  are sold separately on the stock exchange. Once unit creation and sale happens, it is up to the investors to buy and sell these units from the stock exchanges. Since ETF shares are purchased and redeemed directly from the exchange traded funds by financial institutions normally in bulk blocks and are called creation units. Institutional Investors receive or contribute a basket of securities of the same type and proportion held by the concerned ETF. The portfolios of ETF’s are transparent and hence it helpful for institutional investors to decide the assembly of portfolio assets for purchase of a creation unit.

Growing Trend of ETF to become Exotic Traded Funds

Complex New Types of ETPs(Exchange traded products)

Newer types of ETF fail to give the cheapness and diversification of the earlier traditional ones. ETFs are increasingly becoming a source for hedge funds to hedge and speculate on the stock market throughout the span of trading day which in turn allows them to make complex bets on highly illiquid asset classes. The earlier concept of ETFS to encompass a broad range of stocks is quickly giving way to derivative position with counterparty being an investment bank. This growing trend is worrying and it has certainly caught the eye of financial regulators. The Financial Stability Board (FSB), a committee of financial supervisors, issued a report on ETFs. The IMF and Bank for International Settlements (BIS) published global financial stability report and research paper on “Market Structures and Systemic Risks of Exchange-Traded Funds”.

The biggest worry for the regulator surrounds the “Synthetic “ ETFs and derivative linked products popularly known as ETPs( Exchange traded products) of which Exchange-traded notes (ETNs) and Exchange-traded vehicles (ETVs) are popular.

An ETN is basically a debt security issued by a bank or a index provider which gets traded on the market. An ETV is a debt security issued by a special-purpose vehicle.

Since it is almost impractical to replicate a targeted index, most of the ETF provider usually enters into a transaction known as total return swap with a leading bank. The bank is now entrusted with a tedious responsibility and risk of replicating the index. The bank on the other hand agrees to pay the provider an amount almost equivalent to the return on the chosen index benchmark. Since ETF provider has an inherent fear of whether the bank has a risk for going bust and hence requisites them to provide a collateral.

There is a big underlying risk in this financial model. The collateral collected from the bank may have no relevance with the index. Sometimes the collateral can be in the form of equities and bonds and mostly will have no connection with the index. Most of the bonds will be unrated and equity shares have no connection with the index. If the bank were to fail, the index provider will be left with assets which has no correlation whatsoever with the targeted portfolio.

      1)    ETFs as dumping ground for Unwanted Securities

For a Investment Bank to take up the role of mark maker, it necessitates to keep an inventory of debt bonds, equity stocks so as to enable itself with the volatile demands of buying and selling of the client. If the underlying securities are illiquid, the funding can be indeed costly. Once these stocks and bonds act as collateral assets to the ETF provider, the investment banks gets an added advantage of reduced warehousing costs for these assets. Hence the bank raises fund against an illiquid portfolio which left to itself has no ways of funding.

      2)    Lack of Liquidity

  

Not all ETFs enjoy a good liquidity. Since most of the actively managed funds through their expertise fund managers have always managed to outperform ETFs, hence lead to lack of attention to ETFs. E.g. Sensex Prudential ICICI Exchange-Traded Fund (SPICE) is a typical example for poor liquidity. Another striking example is the “Flash Crash” which happened on 6th May 2010 where Dow Jones Industrial Average shed around 1000 points.  Around 75% of the trades were the ETF. Most of the high frequency use ETF funds as a part of their complex arbitrage strategies. Nowadays, most ETFs offer an additional window which facilitates the redemption in the event of inconsistency in the sale of units. Since agents have an instinct to sell products which would fetch them higher commission, ETFs being low-cost products doesn’t pay much of commission failing to attract a rally in market and hence is not a major paying proposition.

      3)    Exposure to Asset Classes like Gold

There has been a spur of interest in Gold ETFs thanks to a rise in the bullion price. Gold ETFs has seen a mass inflow to the tune of $12 billion in 2009 and $9 billion in 2010. The largest gold ETF piled up more bullion than almost all of the world’s central banks san America, France, Germany and Italy. If  all of a sudden investors lose faith, markets can behave hay way as firms compete to take part of their profits.

      4)    ETFs- Bad Products for volatile markets like India

For stock markets of the like of India where there is large amount of volatility where indices are often subjected to periodic churn of going in and going out. This adds a lot of pressure on fund managers to sell off scrip which moves out the index and buy in the scrip which makes a cut into the index. Whenever the ETF fund manager performs the rebalancing act of the portfolio, the scheme has to bear the cost. Hence for unstable indexes which are subjected to constant change in the index to the tune of 10-20%,ETFs are not a good bet.

Growing tendency of ETF managers to top up their income with fees for lending the securities in their portfolio has led to forceful recall of loans in the event of ETF investors wanting their money back in periods of market disruption leading to liquidity pressures.

Conclusion

With the underlying assets being illiquid, ETF is transforming itself into a bet on the credit worthiness of a Bank and parallels are drawn with the failure of mortgage-backed securities. Despite these pitfalls which regulator should take care, ETFs remain as good products and being low cost product can make a part of the portfolio.