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ETFs (Exchange Traded Funds)
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What are ETFs?
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Exchange Traded Funds are essentially Index Funds that are listed and traded on
exchanges like stocks. Until the development of ETFs, this was not possible before.
Globally, ETFs have opened a whole new panorama of investment opportunities to Retail
as well as Institutional Money Managers. They enable investors to gain broad exposure
to entire stock markets in different Countries and specific sectors with relative
ease, on a real-time basis and at a lower cost than many other forms of investing.
An ETF is a basket of stocks that reflects the composition of an Index, like S&P
CNX Nifty or BSE Sensex. The ETFs trading value is based on the net asset value
of the underlying stocks that it represents. Think of it as a Mutual Fund that you
can buy and sell in real-time at a price that changes throughout the day.
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What are benefits of ETFs?
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ETFs offer several advantages to investors : -
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Can easily be bought / sold like any other stock on the exchange through terminals
across the country.
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Can be bought / sold anytime during market hours at a price close to the actual
NAV of the Scheme.
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No separate form filling. Just a phone call to your broker or a click on the net.
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Ability to put limit orders.
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Minimum investment is one unit.
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Enjoy flexibility of a stock and diversification of index fund.
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Expense Ratio is lower.
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Provides arbitrage between Futures and Cash Market.
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Are ETFs popular worldwide?
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ETFs are very popular abroad with nearly 60% of trading volumes on the American
Stock Exchange (AMEX) captured by ETFs. At the end of March 2008, there were over
1280 ETFs with assets of US$ 760.80 billion managed by 79 managers across 42 exchanges
around the World. Among the popular ones are : -
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SPDRs - The S&P 500 Depository Receipts were the first ETFs to be in the market
in 1993. SPDRs track the S&P 500. There are select sector SPDR funds available.
These are traded on the AMEX.
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Can be bought / sold anytime during market hours at a price close to the actual
NAV of the Scheme.
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QQQs - Popularly known as Cubes, they are listed on the NASDAQ and track the NASDAQ
-100. It is one of the most liquid ETFs.
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iShares - World Equity Benchmark Shares are listed on the AMEX and offer investors
access to 17 foreign markets. iShares track the Morgan Stanley Capital International
(MSCI) Indices.
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TRAHK - Trahks is listed on the Stock of Exchange of Hong Kong and the investment
objective is to provide investment results that closely correspond to the performance
of the Hang Seng Index.
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TRAHK - Represents an undivided beneficial ownership in common stock of a group
of several companies within a specified industry. HOLDRs are unlike other ETFs,
which add and drop shares depending on changes in the underlying Index. In HOLDRs,
the underlying securities once pre-defined do not change unless due to mergers,
acquisitions or other occurrences that lead to the termination of the common shares
of the Company.
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What are the costs of investing in ETFs through the exchange?
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While the Expense Ratio of ETFs is generally low, there are certain costs that are
unique to ETFs. Since ETFs, like stocks, are bought as shares through a broker,
every time an investor makes a purchase, he/she pays a brokerage commission. In
addition, an investor can suffer the usual costs of trading stocks, including differences
in the ask-bid spread etc. Of course, traditional Mutual Fund investors are also
subjected to the same trading costs indirectly, as the Fund in turn pays for these
costs.
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How does the in-kind creation / redemption mechanism work in ETFs?
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ETFs can either be purchased on the Exchange or directly with the Fund. The Fund
creates / redeems units only in predefined lot sizes in exchange for a predefined
underlying portfolio basket. Once the underlying portfolio basket is deposited with
the Fund together with a cash component, the investor is allotted the units.
This is in-kind creation / redemption of units, unique to ETFs.
Alternatively, investors can follow the "Cash Subscription" route in which they
can pay cash directly to the Fund for purchasing the underlying portfolio.
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Why do ETFs trade close to their NAV?
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ETFs have a very transparent portfolio holding and predefined creation basket. This
allows arbitrageurs to create and redeem units every day through the in-kind creation
/ redemption mechanism. Such arbitrageurs are always in the market to take advantage
of any significant premium or discount between the ETF market price and its NAV
by doing arbitrage between the ETF and its underlying portfolio.
Thus, the open architecture of ETFs ensures that there is no significant premium
or discount to NAV. At the same time, additional demand / supply is absorbed due
to the action of the arbitrageurs.
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How do ETFs derive their liquidity?
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ETFs derive their liquidity first from trading of the units in the Secondary Market
and second through the in-kind creation / redemption process with the Fund in creation
unit size.
Due to the unique in-kind creation / redemption process of ETFs, the liquidity of
an ETF is actually the liquidity in the underlying shares.
What are the advantages of ETFs over normal open-ended mutual fund?
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Buying / Selling ETFs is as simple as buying / selling any other stock on the exchange.
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ETFs allow investors to take benefit of intraday movements in the market, which
is not possible with open-ended Funds.
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With ETFs one pays lower management fees. As ETFs are listed on the Exchange, distribution
and other operational expenses are significantly lower, making it cost effective.
These savings in cost are passed on to the investor.
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ETFs have lower tracking error due to in-kind creation and redemption.
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Due to its unique structure, the long-term investors are insulated from short term
trading in the fund.
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What are the differences between ETFs and close-ended mutual funds?
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Though Close-Ended Mutual Funds are listed on the exchange they have a limited number
of shares and trade at substantial premiums or more often at discounts to the actual
NAV of the scheme. Also, they lack the transparency, as one does not know the constitution
and value of the underlying portfolio on a daily basis.
In ETFs, the number of units issued are not limited and can be created / redeemed
throughout the day. ETFs rely on market makers and arbitrageurs to maintain liquidity
so as to keep the price in line with the actual NAV.
Comparison of ETFs v/s Open Ended Funds v/s Close Ended Funds:
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Fund Size
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Flexible
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Fixed
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Flexible
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NAV
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Daily
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Daily
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Real-Time
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Liquidity Provider
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Fund Itself
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Stock Market
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Stock Market / Fund Itself
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Availability
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Fund Itself
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Through Exchange where listed
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Through Exchange where listed / Fund itself.
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Portfolio Disclosure
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Disclosed monthly
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Disclosed monthly
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Daily/Real-time
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Intra-Day Trading
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Not possible
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Expensive
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Possible at low cost
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For whom are ETFs suitable ?
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A broad class of investors can use ETFs:
The major players in this market have historically been Large Institutional players
seeking to Index core holdings or pursue more aggressive market timing and sector
rotation strategies. However, since Smaller Institutions and Retail Investors can
trade in small lots, they can invest in essentially the same terms as Large Investors.
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For Retail or Wholesale Investors with a long-term horizon, it allows diversification
of portfolio with one single investment. It insulates them from short term trading
activity of other investors in the Fund as ETFs have a unique in-kind creation /
redemption mechanism. Lower costs of ETFs enhance net returns in the long term.
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For FIIs, Institutions and Mutual Funds, it allows easy Asset Allocation, Hedging
and Equitising Cash at a low cost.
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For Arbitrageurs, it provides ease with low Impact Cost to carry out arbitrage between
the Cash and the Futures market.
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For investors with a shorter term horizon, ETFs provides access to liquidity due
to the ability to trade during the day and at values near to NAV.
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What are the USES OF ETFs?
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Asset Allocation : Asset allocation managing could be difficult for individual
investors given the costs and assets required to achieve proper levels of diversification.
ETFs provide investors with exposure to broad segments of the equity markets. They
cover a range of style and size spectrums, enabling investors to build customized
investment portfolios consistent with their financial needs, risk tolerance, and
investment horizon. Both institutional and individual investors use ETFs to conveniently,
efficiently, and cost effectively allocate their assets.
Cash Equitisation : Investors typically seek exposure to equity markets,
but often need time to make investment decisions. ETFs provide a "Parking Place"
for cash that is designated for equity investment. Because ETFs are liquid, investors
can participate in the market while deciding where to invest the funds for the longer-term,
thus avoiding potential opportunity costs. Historically, investors have relied heavily
on derivatives to achieve temporary exposure. However, derivatives are not always
a practical solution. The large denomination of most derivative contracts can preclude
investors, both Institutional and Individual, from using them to gain market exposure.
In this case and in those where derivative use may be restricted, ETFs are a practical
alternative.
Hedging Risks : ETFs are an excellent hedging vehicle because they can be
borrowed and sold short. The smaller denominations in which ETFs trade relative
to most derivative contracts provides a more accurate risk exposure match, particularly
for small investment portfolios.
Arbitrage (Cash Vs Futures) and Covered Option Strategies: ETFs can be used
to arbitrage between Cash and Futures Market, as it is very easy to trade. ETFs
can also be used for cover Option strategies on the Index.
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What happens to dividends?
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Dividends received by the Scheme will be reinvested in the scheme. However, the
Fund may also decide to distribute dividends to the investors.
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What are the rules governing taxation of ETFs?
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Same rules apply as in the case of buying or selling stocks or mutual fund units.
Kindly refer the respective Offer Document /Key Information Memorandum
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What happens if constituents in the underlying index change?
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Constituents of an Index are changed as and when Securities in the Index do not
match specific criteria laid down by the Index Service Provider or a better candidate
is available to replace a constituent. The Index Service Provider usually makes
announcements of change well in advance. Once Securities in the underlying index
are changed, the Fund would change the Securities in its underlying portfolio by
selling the Securities that are being removed from the Index and including those
that are included in the Index. This will in no way affect the units being held
by an investor, as the units will continue to track the index. The only effect may
be on the tracking error of the scheme.
Index changes are usually not so frequent. In India, historically, around 10%of
the Index constituents have changed annually which means an index of 50 securities
would experience about 5 changes every year.
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How do ETFs compare with Index Futures?
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Index Futures have gained wide acceptance globally as a tradeable means of shifting
exposure to Indices. Index Futures are advantageous when the implied Cost of Carry
is less than the actual Cost of Carry. In addition, an investment in ETFs requires
investment of the entire notional value, while an investment in Futures requires
posting of an initial collateral deposit and then daily Market to Market Margins
which represent a small fraction of the notional value, allowing leverage.
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ETFs are beneficial over Index Futures in many situations:
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When investors cannot or prefer not to trade Index Futures
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When cash flows are small and investors do not have
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For longer-term horizons, Index Futures need to be rolled over every month /quarter
which has its own risk and costs
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If regulations prevent investors from investing in Futures;
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Taxation issues: With Index Futures investors can avail of only short-term capital
gains while with ETFs, investors can avail long-term capital gains.
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If the discount in ETFs is greater than the discount in futures
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GS Nifty BeES
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Goldman Sachs Asset Management (India) Private Limited
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S&P CNX Nifty Index
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www.gsam.in
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GS Junior BeES
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Goldman Sachs Asset Management (India) Private Limited
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CNX Nifty Junior Index
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www.gsam.in
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GS Liquid BeES
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Goldman Sachs Asset Management (India) Private Limited
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Crisil Liquid Fund Index
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www.gsam.in
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GS Bank BeES
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Goldman Sachs Asset Management (India) Private Limited
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CNX Bank Index
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www.gsam.in
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GS Gold BeES
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Goldman Sachs Asset Management (India) Private Limited
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Price Of Gold
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www.gsam.in
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GS PSU Bank BeES
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Goldman Sachs Asset Management (India) Private Limited
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CNX PSU Bank Index
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www.gsam.in
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