Monday, December 11, 2006

… Curtains down on Classification…Specialty Funds

… Curtains down on Classification…

Specialty Funds

This classification of mutual funds is more of an all-encompassing category that consists of funds that have proved to be popular but don't necessarily belong to the categories that have been described so far.
Exchange Traded Fund

An Exchange Traded Fund (ETF) is a hybrid financial product, a cross between a stock and a mutual fund. Like a stock it can be traded on a stock exchange and like a mutual fund it behaves like a diversified portfolio and invests in the stocks of an index in approximately the same proportion as held in the index.
The ETFs represent ownership in a fund. Each ETF is designed as a share. Shares are only created or redeemed by institutional investors in large blocks (typically 50,000 shares). Investors purchase shares in small quantities through brokers at a small premium or discount to the net asset value through which the institutional investors make their profit.

The pros and cons of ETF investing are lucidly summed up below:
  • ETFs replicate index products, although some benchmarks may be new and not have a track record;
  • ETFs have lower expenses (institutional investors handle the majority of trades) and are tax efficient. ETFs do not buy and sell stocks, except to replace a stock that has been replaced on an index. Readjustments might generate small capital gains for investors, but generally the investor faces a tax liability only when he sells the ETF shares for a gain;
  • ETFs trade throughout the day, giving investors flexibility;
  • ETFs can be bought on margin;
  • Buying or selling an ETF triggers a commission since it is bought through a broker. This may not be advantageous to someone investing every month or quarter.
Small investors, used to investing in units, need to remember that unlike mutual funds, the ETFs do not necessarily trade on NAV. Like stocks, they may trade at a premium or at a discount. This means that even if the underlying stocks in the basket are doing well, investors may still book a loss by buying the ETFs being traded at a discount. This apart, the ETFs may also be subject to a bid-ask spread. Simply explained, it means that while one may be able to buy an ETF at Rs 16.50 per share, he may be able to sell only at Rs 16. The 50 paise that he is unable to recover, denotes a hidden cost, which may be unknown to a novice not fully conversant with the downside of the new instrument. The ETFs are also not appropriate for investors who "rupee-cost average" their purchases or redemptions as they would have to pay brokerages on each transaction.

India joined the ETF club in December 2001 with the launch of India's first ETF 'Nifty BeES' (Nifty Benchmark Exchange-traded Scheme) by Benchmark Mutual Fund, based on the S&P CNX Nifty Index. Since then, Benchmark has launched the Junior BeES and the Liquid BeES. There are five ETFs in India at present, of which three are based on the 50-share S&P CNX Nifty index ( including SUNDER by UTI), one on the 200-share CNX Nifty Junior, and one on the 30-share BSE Sensex (SPICE by Prudential ICICI).

India is soon slated to begin trading the Gold Exchange Traded Fund (GETF) which will track the price of gold. Its appointed custodians will buy and sell gold bullion as investors initiate or offset positions in the ETF. An issue currently being resolved concerns who the custodian(s) of the underlying metal will be, and where it will be stored. Rather than outsourcing this activity, it appears that domestic banks will become gold custodians, leading to the launch of several other ETFs by Indian fund houses.

ETFs open up a world of new possibilities to investors whose investment habits have thus far been honed only on investing in pure equity, debt, units and, recently, derivatives. But domestic investors, still not conversant with the downside of investing in the capital market, need to first evaluate if the ETFs are the best investment option going for them, before taking the plunge. While they look more attractive compared to open-ended mutual funds, there are several hidden costs and charges involved in dealing with the ETFs, which need to be factored before investors "spice" up their portfolios.

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