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Knowledge Corner

Mutual Fund Investing-III

INTRODUCTION TO EXCHANGE TRADED FUNDS
Exchange Traded Funds (ETFs) are mutual fund units which investors buy/ sell from the stock exchange, as against a normal mutual fund unit, where the investor buys / sells through a distributor or directly from the AMC. ETF as a concept is relatively new in India. It was only in early nineties that the concept gained in popularity in the USA. ETFs have relatively lesser costs as compared to a mutual fund scheme. This is largely due to the structure of ETFs. While in case of a mutual fund scheme, the AMC deals directly with the investors or distributors, the ETF structure is such that the AMC does not have to deal directly with investors or distributors. It instead issues units to a few designated large participants, who are also called as Authorized Participants (APs), who in turn act as market makers for the ETFs.
The Authorized Participants provide two way quotes for the ETFs on the stock exchange, which enables investors to buy and sell the ETFs at any given point of time when the stock markets are open for trading. ETFs therefore trade like stocks. Buying and selling ETFs is similar to buying and selling shares on the stock exchange. Prices are available on real time and the ETFs can be purchased through a stock exchange broker just like one would buy / sell shares. There are huge reductions in marketing expenses and commissions as the Authorized Participants are not paid by the AMC, but they get their income by offering two way quotes on the floor of the exchange. Due to these lower expenses, the Tracking Error for an ETF is usually low. Tracking Error is the acid test for an index fund/ ETF. By design an index fund/ index ETF should only replicate the index return. The difference between the returns generated by the scheme/ ETF and those generated by the index is the tracking error.
Assets in ETFs
Practically any asset class can be used to create ETFs. Globally there are ETFs on Silver, Gold, Indices (SPDRs, Cubes, etc), etc. In India, we have ETFs on Gold, Indices such as Nifty, Bank Nifty etc.).
Index ETF
An index ETF is one where the underlying is an index, say Nifty. The APs deliver the shares comprising the Nifty, in the same proportion as they are in the Nifty, to the AMC and create ETF units in bulk (These are known as Creation Units). Once the APs get these units, they provide liquidity to these units by offering to buy and sell through the stock exchange. They give two way quotes, buy and sell quote for investors to buy and sell the ETFs. ETFs therefore have to be listed on stock exchanges. There are many ETFs presently listed on the NSE.
SALIENT FEATURES OF ETF
An Exchange Traded Fund (ETF) is essentially a scheme where the investor has to buy/ sell units from the market through a broker (just as he/ he would by a share). An investor must have a demat account for buying ETFs (For understanding what is Demat please refer to NCFM module ‘Financial Markets: A Beginners’ Module).
An important feature of ETFs is the huge reduction in costs. While a typical Index fund would have expenses in the range of 1.5% of Net Assets, an ETF might have expenses around 0.75%. In fact, in international markets these expenses are even lower. In India too this may be the trend once more Index Funds and ETFs come to the market and their popularity increases. Expenses, especially in the long term, determine to a large extent, how much money the investor makes. This is because lesser expenses mean more of the investor’s money is getting invested today and over a longer period of time, the power of compounding will turn this saving into a significant contributor to the investors’ returns.
For example, If an investor invests Rs 10,000 in 2 schemes each, for 25 years, with both the schemes delivering returns at a CAGR of 12% and the only difference being in the expenses of the schemes, then at the end of the term, while scheme A would have turned the investment into Rs 1.16 Lakhs, scheme B would have grown to Rs 1.40 Lakhs – a difference of Rs 24,327.77! Post expenses, scheme A’s CAGR comes out to be 10.32%, while scheme B’s CAGR stands at 11.16%.
GOLD ETFs
Gold ETF’s are a special type of ETF which invests in Gold and Gold related securities. This product gives the investor an option to diversify his investments into a different asset class, other than equity and debt. Traditionally, Indians are known to be big buyers of Gold; an age old tradition. G-ETFs can be said to be a new age product, designed to suit our traditional requirements. We buy Gold, among other things for children’s marriages, for gifting during ceremonies etc. Holding physical Gold can have its’ disadvantages:
  • Fear of theft
  • Payment Wealth Tax
  • No surety of quality
  • Changes in fashion and trends
  • Locker costs
  • Lesser realization on remolding of ornaments
G-ETFs score over all these disadvantages, while at the same time retaining the inherent advantages of gold investing. In case of Gold ETFs, investors buy Units, which are backed by Gold. Thus, every time an investor buys 1 unit of G-ETFs, it is similar to an equivalent quantity of Gold being earmarked for him somewhere. Thus his units are ‘as good as Gold’.
For example 1 G-ETF = 1 gm of 99.5% pure Gold, then buying 1 G-ETF unit every month for 20 years would have given the investor a holding of 240 gm of Gold, by the time his child’s marriage approaches (240 gm = 1 gm/ month * 12 months * 20 Years). After 20 years the investor can convert the G-ETFs into 240 gm of physical gold by approaching the mutual fund or sell the G-ETFs in the market at the current price and buy 240 gm of gold.
Secondly, during the tenure of the holding, the investor need not worry about theft, locker charges and quality of Gold or changes in fashion as he would be holding Gold in paper form. As and when the investor needs the Gold, he may sell the Units in the market and realize an amount equivalent to his holdings at the then prevailing rate of Gold ETF. This money can be used to buy physical gold and make ornaments as per the prevailing trends. The investor may also simply transfer the units to his child’s demat account as well! Lastly, the investor will not have to pay any wealth tax on his holdings. There may be other taxes, expenses to be borne from time to time, which the investor needs to bear in mind while buying / selling G-ETFs.
WORKING
The G-ETF is designed as an open ended scheme. Investors can buy/ sell units any time at the prevailing market price. This is an important point of differentiation of ETFs from similar open ended funds. In the case of open ended funds, investors get units (or the units are redeemed) at a price based upon that day’s NAV. In case of ETFs, investors can buy (or sell) units at a price which is prevailing at that point of time during market hours. Thus for all investors of open ended schemes, on any given day their buying (or redemption) price will be same, whereas for ETF investors, the prices will vary for each, depending upon when they bought (or sold) units on that day.
The Gold which the AP deposits for buying the bundled ETF units is known as ‘Portfolio Deposit’. This Portfolio Deposit has to be deposited with the Custodian. A custodian is someone who handles the physical Gold for the AMC. The AMC signs an agreement with the Custodian, where all the terms and conditions are agreed upon. Once the AP deposits Gold with the custodian, it is the responsibility of the custodian to ensure safety of the Gold, otherwise he has to bear the liability, to the extent of the market value of the Gold. The custodian has to keep record of all the Gold that has been deposited/ withdrawn under the G-ETF. An account is maintained for this purpose, which is known as ‘Allocated Account’.
The custodian, on a daily basis, enters the inflows and outflows of Gold bars from this account. All details such as the serial number, refiner, fineness etc. are maintained in this account. The transfer of Gold from or into the Allocated Account happens at the end of each business day. A report is submitted by the custodian, no later than the following business day, to the AMC. The money which the AP deposits for buying the bundled ETF units is known as ‘Cash Component’. This Cash Component is paid to the AMC. The Cash Component is not mandatory and is paid to adjust for the difference between the applicable NAV and the market value of the Portfolio Deposit. This difference may be due to accrued dividend, management fees, etc. The bundled units (which the AP receives on payment of Portfolio Deposit to the custodian and Cash Component to the AMC) are known as Creation Units. Each Creation Unit comprises of a predefined number of ETFs Units (say 25,000 or 100 or any other number).
Thus, now it can be said that Authorized Participants pay Portfolio Deposit and/ or Cash Component and get Creation Units in return. Each Creation Unit consists of a pre defined number of G-ETF Units. APs strip these Creation Units (which are nothing but bundled G-ETF units) and sell individual G-ETF units in the market. Thus retail investors can buy/ sell 1 unit or it’s multiples in the secondary market.
DEBT FUNDS
SALIENT FEATURES
Debt funds are funds which invest money in debt instruments such as short and long term bonds, government securities, t-bills, corporate paper, commercial paper, call money etc. The fees in debt funds are lower, on average, than equity funds because the overall management costs are lower. The main investing objectives of a debt fund are usually preservation of capital and generation of income. Performance against a benchmark is considered to be a secondary consideration. Investments in the equity markets are considered to be fraught with uncertainties and volatility. These factors may have an impact on constant flow of returns and this is why debt schemes are considered to be safer and less volatile have attracted investors.
Debt markets in India are wholesale in nature and hence retail investors generally find it difficult to directly participate in the debt markets. Not many understand the relationship between interest rates and bond prices or difference between Coupon and Yield. Therefore venturing into debt market investments is not common among investors. Investors can however participate in the debt markets through debt mutual funds. One must understand the salient features of a debt paper to understand the debt market. Debt paper is issued by Government, corporates and financial institutions to meet funding requirements. A debt paper is essentially a contract which says that the borrower is taking some money on loan and after sometime the lender will get the money back as well as some interest on the money lent. Prima facie this arrangement looks risk free.
However two important questions need to be asked here:
  • What if interest rates rise during the tenure of the loan?
  • What if the borrower fails to pay the interest and/ or fails to repay the principal?
In case interest rates rise, then the investor’s money will continue to grow at the earlier fixed rate of interest; i.e. the investor loses on the higher rate of interest, which his money could have earned. In case the borrower fails to pay the interest it would result in an income loss for the investor and if the borrower fails to repay the principal, it would mean an absolute loss for the investor. A prospective debt fund investor must study both these risks carefully before entering debt funds.
INTEREST RATE RISK
The first risk which we discussed is known as the Interest Rate Risk. This can be reduced by adjusting the maturity of the debt fund portfolio, i.e. the buyer of the debt paper would buy debt paper of lesser maturity so that when the paper matures, he can buy newer paper with higher interest rates. So, if the investor expects interest rates to rise, he would be better off giving short-term loans (when an investor buys a debt paper, he essentially gives a loan to the issuer of the paper). By giving a short-term loan, he would receive his money back in a short period of time. As interest rates would have risen by then, he would be able to give another loan (again short term), this time at the new higher interest rates. Thus in a rising interest rate scenario, the investor can reduce interest rate risk by investing in debt paper of extremely Short-term maturity.
CREDIT RISK
The second risk is known as Credit Risk or Risk of Default. It refers to the situation where the borrower fails to honor either one or both of his obligations of paying regular interest and returning the principal on maturity. A bigger threat is that the borrower does not repay the principal. This can happen if the borrower turns bankrupt. This risk can be taken care of by investing in paper issued by companies with very high Credit Rating. The probability of default of a borrower with very high Credit rating is far lesser than that of a borrower with low credit rating. Government paper [securities] is the ultimate in safety when it comes to credit risk (hence the description ‘risks free security’). This is because the Government will never default on its obligations. If the Government does not have cash (similar to a company going bankrupt), it can print more money to meet its obligations or change the tax laws so as to earn more revenue (neither of which a corporate can do!).
DEBT INSTRUMENT PRICING
Debt fund investing requires a different analysis, and understanding of basic bond market concepts is essential. There exist some relationships between yields and bond prices, between years to maturity and impact of change in interest rates, between credit risk and yields, and so on. We need to understand each of these relationships before we can start investing in debt funds.
The price of an instrument (equity / bond) is nothing but the present value of the future cash flows. (For understanding the meaning of present value, please refer to NCFM module ‘Financial Markets: A Beginners Module’). In case of bonds, there is no ambiguity about future cash flows, as is the case of equities. Future cash flows in case of bonds are the periodic coupon payments that the investor will receive. Future cash flows for equities are the dividends than the investor may receive. Bond coupon payments are known right at the beginning, whereas there is no surety about a share paying dividends to an investor. Thus different investors/ analysts have different earning projections for equities, and hence each participant has a different view on the present value of a share. Bond cash flows being known, there is no confusion about what the present value of each future cash flow should be. An important factor in bond pricing is the Yield to Maturity (YTM). This is rate applied to the future cash flow (coupon payment) to arrive at its present value. If the YTM increases, the present value of the cash flows will go down. This is obvious as the YTM appears in the denominator of the formula, and we know as the denominator increases, the value of the ratio goes down. So here as well, as the YTM increases, the present value falls. price of a bond is the present value of future cash flows. Hence if the present value goes down, due to increase in YTM, then the sum will also go down. This brings us to an important relation – As interest rates go up, bond prices come down.
For example, let us say a bond is issued with a term to maturity of 3 years, coupon of 8% and face value of Rs. 100. Obviously, the prevailing interest rates during that time have to be around 8%. If the prevailing rates are higher, investors will not invest in a 8% coupon bearing bond, and if rates are lower, the issuer will not issue a bond with 8% coupon, as a higher coupon means higher interest payments for the issuer.
DEBT MUTUAL FUND SCHEMES
Fixed Maturity Plans
FMPs have become very popular in the past few years. FMPs are essentially close ended debt schemes. The money received by the scheme is used by the fund managers to buy debt securities with maturities coinciding with the maturity of the scheme. There is no rule which stops the fund manager from selling these securities earlier, but typically fund managers avoid it and hold on to the debt papers till maturity. Investors must look at the portfolio of FMPs before investing. If an FMP is giving a relatively higher ‘indicative yield’, it may be investing in slightly riskier securities. Thus investors must assess the risk level of the portfolio by looking at the credit ratings of the Securities. Indicative yield is the return which investors can expect from the FMP. Regulations do not allow mutual funds to guarantee returns, hence mutual funds give investors an idea of what returns can they expect from the fund. An important point to note here is that indicative yields are pre-tax. Investors will get lesser returns after they include the tax liability.
Capital Protection Funds
These are close ended funds which invest in debt as well as equity or derivatives. The scheme invests some portion of investor’s money in debt instruments, with the objective of capital protection. The remaining portion gets invested in equities or derivatives instruments like options. This component of investment provides the higher return potential. It is beyond the scope of this book to explain how Options work. For that you may need to refer to NCFM modules ‘Financial Markets: A Beginners’ Module’ or ‘Derivatives Markets (Dealers) module’. It is important to note here that although the name suggests ‘Capital Protection’, there is no guarantee that at all times the investor’s capital will be fully protected.
Gilt Funds
These are those funds which invest only in securities issued by the Government. This can be the Central Govt. or even State Govt. Gilt funds are safe to the extent that they do not carry any Credit Risk. However, it must be noted that even if one invests in Government Securities, interest rate risk always remains.
Balanced Funds
These are funds which invest in debt as well as equity instruments. These are also known as hybrid funds. Balanced does not necessarily mean 50:50 ratio between debt and equity. There can be schemes like MIPs or Children benefit plans which are predominantly debt oriented but have some equity exposure as well. From taxation point of view, it is important to note how much portion of money is invested in equities and how much in debt. This point is dealt with in greater detail in the chapter on Taxation.
MIPs
Monthly Income Plans (MIPs) are hybrid funds; i.e. they invest in debt papers as well as equities. Investors who want a regular income stream invest in these schemes. The objective of these schemes is to provide regular income to the investor by paying dividends; however, there is no guarantee that these schemes will pay dividends every month. Investment in the debt portion provides for the monthly income whereas investment in the equities provides for the extra return which is helpful in minimizing the impact of inflation.
Child Benefit Plans
These are debt oriented funds, with very little component invested into equities. The objective here is to capital protection and steady appreciation as well. Parents can invest in these schemes with a 5 – 15 year horizon, so that they have adequate money when their children need it for meeting expenses related to higher education.
LIQUID FUNDS
SALIENT FEATURES
By far the biggest contributor to the MF industry, Liquid Funds attract a lot of institutional and High Net worth Individuals (HNI) money. It accounts for approximately 40% of industry AUM. Less risky and better returns than a bank current account are the two plus points of Liquid Funds. Money Market instruments have maturities not exceeding 1 year. Hence Liquid Funds (also known as Money Market Mutual Funds) have portfolios having average maturities of less than or equal to 1 year. Thus such schemes normally do not carry any interest rate risk. Liquid Funds do not carry Exit Loads. Other recurring expenses associated with Liquid Schemes are also kept to a bare minimum.
FLOATING RATE SCHEME
These are schemes where the debt paper has a Coupon which keeps changing as per the changes in the interest rates. Thus there is no price risk involved in such paper. We know when rates go up, bond prices go down. However, if the rates increase and so also the coupon changes and increases to the level of the interest rates, there is no reason for the price of the paper to fall, as the investor is compensated by getting higher coupon, in line with the ongoing market interest rates. Investors prefer Floating Rate funds in a rising interest rate scenario.
LIQUID FUNDS
A liquid fund will constantly change its portfolio. This is because the paper which it invests in is extremely short term in nature. Regularly some papers would be maturing and the scheme will get the cash back. The fund manager will use this cash to buy new securities and hence the portfolio will keep changing constantly. As can be understood from this, Liquid Funds will have an extremely high portfolio turnover. Liquid Funds see a lot of inflows and outflows on a daily basis. The very nature of such schemes is that money is parked for extremely short term. Also, investors opt for options like daily or weekly dividend. All this would mean, the back end activity for a liquid fund must be quite hectic – due to the large sizes of the transactions and also due to the large volumes. As in equities, we have different index for large caps, Midcaps & Small caps, similarly in bonds we have indices depending upon the maturity profile of the constituent bonds. Thus for a portfolio comprising of long term bonds, we have the Li-Bex, for the midterm bond portfolio, we have the Mi-Bex and for the Liquid Funds we have the Si-Bex as the underlying indices.
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