The idea of investing in Index funds goes back to quite a time. Though ETFs are quite different from Index Funds in terms of the structure, they do have certain common similarities in terms of the investment objective behind choosing these products. Moreover ETFs are a broader set and moves beyond the scope of Indices. Today one can purchase Gold ETFs, Sectoral ETFs or Thematic ETFs too.
From one fund in 1993, the ETF market grew to 102 funds in 2002 and nearly 1,000 by the end of 2009; ETF data base lists over 1,400 ETFs in its database as of Dec. 20, 2011. By the end of 2011 it looked as though total assets under management at ETFs would approach or exceed $1.1 trillion, a sizable amount of money, but still very small compared to the nearly $12 trillion that is held by mutual funds.
Along the way, an interesting “competition” of sorts had started between ETFs and mutual funds. 2003 marked the first year where ETF net inflows exceeded those of mutual funds. Since then, mutual fund inflows have typically exceeded ETF inflows during years where market returns are positive, but ETF net inflows tend to be superior in years where the major markets are weak.
The key to understanding how ETFs work is the “creation/redemption” mechanism. It’s how ETFs gain exposure to the market, and is the “secret sauce” that allows ETFs to be less expensive, more transparent and more tax efficient than traditional mutual funds.
How ETFs are created or issued?
While ETF trading occurs on an exchange like shares, the process by which their units are created is significantly different. Unless a company decides to issue more shares, the supply of shares of an individual stock trading in the marketplace is finite. However, when demand increases for units of an ETF, Authorised Participants (APs) have the ability to create additional units on demand.
In creating and issuing ETFs to end-investors there are two markets at work:
- The primary market – where investment companies like reliance build ETFs and authorised Participants (APs) create and redeem ETF units.
- The secondary market – where authorized Market Makers seek to provide liquidity and investors buy and sell ETFs on a stock exchange (such as NIFTY) through brokers or financial advisers.
THE PRIMARY MARKETS AND CREATING ETF UNITS
The primary market is where ETFs are created and redeemed.
The process of creating and redeeming ETFs
- Investment companies (such as Reliance), acting as an ETF Issuer, identify or construct an index based on an investment objective. They then build an ETF that invests in a basket of underlying securities reflecting the index
- The Issuer lists the ETF on the exchange
- Authorised Participants (APs) create ETF units, through a transfer mechanism, whereby they
A) apply to the ETF Issuer to receive ETF units.
B) deliver a basket of the underlying securities and/or any cash component to the Issuer, as specified by the Issuer.
C) in return, the Issuer delivers a large block of ETF units (called a Creation Unit which typically holds 50,000 shares) to the AP.
- The underlying securities and/or any cash are transferred to the Fund’s custodian. The custodian is appointed by the Issuer
- The AP is then able to on-trade the ETF units on the secondary market, with each unit representing a proportional holding in the underlying securities
Often you will find an AP will also act as a Market Maker on the secondary market.
The redemption process is effectively the creation process in reverse, where an AP gathers the minimum block of units in the ETF to form what is called a Redemption Unit and then exchanges this with the Issuer for the underlying securities.
Important points to note about the creation and redemption process
- New units can be created or redeemed as required to meet investor demand and supply.
- The ETF creation and redemption process helps keep ETF supply and demand in continual balance and provides a “hidden” layer of liquidity not evident by looking at trading volumes alone.
- Because units are typically created and redeemed between APs and Issuers in the primary market, capital gains can be allocated to the redeeming unit holder rather than remain with existing investors in the fund. As a result, the structure of the ETF allows the CGT(CAPITAL GAINS TAX) liability resulting from a redemption to be passed on to the redeeming AP.
- Individual investors cannot buy ETFs on the primary market and must transact on the secondary market.
SECONDARY MARKET OF ETFs: BUYING & SELLING ETFs
The secondary market is where investors can buy and sell ETFs units, just like shares.
- Similar to shares listed on the EXCHANGE, ETF units can be bought or sold through brokers (including online brokers) and traded anytime during trading hours. There is no minimum investment size.
- ETF investors can use all the trading strategies associated with shares such as market orders, limit orders, stop orders, short sales and margin lending. Like any share listed on the EXCHANGE..
- The ETF unit price, which is also known as the ‘Net Asset Value’ (NAV) is based on the total value of the underlying holdings of the ETF divided by the number of outstanding units on issue. The NAV is declared each day after the market close. Due to the transparency of the holdings and the fact that the units on issue can change with supply and demand, this generally ensures that ETFs will trade at prices throughout the day close to the NAV of the ETF.
HOWEVER ON GROUND OF TAXATION, AN INDEX ETF IS TAXED AT 15% FOR SHORT TERM CAPITAL GAIN AND AT 0 % FOR LONG TERM CAPITAL GAIN.
NOTE- STANDARD SECURITIES TRANSACTION TAX IS LEVIED ON ETF @ .125%
Case of reliance mutual ETF -Everyone is aware about the reliance mutual funds. Somehow till now we know the core difference between working of a mutual fund and working of an ETF. So is the case of reliance ETF CPSE (central public sector enterprise).
What is the CPSE Index?
NATIONAL STOCK EXCHANGE launched CPSE Index in order to facilitate the government disinvest some of its stake in as many as 10 blue-chip public sector enterprises.
The 10 major CPSEs (Central Public Sector Enterprises) that will form part of the new index are: Coal India, GAIL (India), Oil & Natural Gas Corporation, Indian Oil Corporation, Bharat Electronics, Oil India, Power Finance Corporation, Rural Electrification Corporation, Container Corporation of india and Engineers India.
The CPSE ETF based on the CPSE Index gives investors an opportunity of cost-efficient investment in blue-chip public sector companies across sectors,” it added.
So, is the case of reliance mutual fund ETF and through this ETF government has raised approximately 9000 in the first two tranches and is looking forward to raise more amount as government of India is keen on its divestment plan on selected public sector enterprises.