The 'killer apps'

SMARTSHARE

The exchange traded fund (ETF) is a hybrid financial product that combines some of the properties of common shares with the properties of mutual fund units. ETFs level the playing field for small but serious investors as well as offering serious advantages to big players.

An ETF helps a passive investor capture the index return but it can also be used as a hedge in a way that mutual units cannot. An ETF's Net Asset Value (NAV) is fixed in direct proportion to the index value, just like the NAV of an index mutual fund.

But there are key differences. ETF units are traded on the exchange like shares with the NAV tied to the constantly fluctuating index. Mutual fund units are directly offered by the asset management company (AMC) with a NAV tied to closing price of the previous session.

For example, consider the Spice ETF (BSE code: 555555), an instrument designed through a collaboration of Prudential-ICICI AMC with the BSE.

Spice units are each fixed at 1/100 of Sensex value and a trading lot consists of just one unit. Units are traded through BSE terminals like listed BSE shares.

The Spice NAV is currently about Rs 66 per unit at 1/100th of current Sensex value. There are no entry-exit loads on Spice, just brokerage charges.

Like shampoo sachets, ETFs are affordable to all because of the tiny minimum investment. ETFs also attract big traders because they are liquid and transparently priced. A major investor can actually create a "creation lot" of a minimum 25,000 Spice units through a slightly complex process.

While an ETF doesn't have the leverage of an index future, it is not a time-bound asset. Units can be held indefinitely like open-ended index mutual funds. Spice units can also be cashed in anytime for the underlying basket of shares.

The AMC/stock exchange will extinguish Spice units on demand and offer the shares of the underlying 30 Sensex stocks in exchange. This exchange system enhances hedging value and minimises tracking error.

In theory, ETFs ought to generate big volumes given the low entry costs, low investment requirements and high hedge-value. Also in theory, ETFs should trade close to current NAV. However, since traders make normal bids/offers, units may actually trade at considerable premiums or discounts.

In practice, Spice traded on Wednesday at Rs 167, at over 150 per cent premium. The volumes were paltry; total turnover was just 1,553 units.

This is an absurd case of mis-pricing caused by illiquidity and perhaps, by misconceptions about the nature of ETFs. There's no ETF circuit filter and Spice has gained 120 percent in traded price in the past week.

The BSE has been seriously perturbed. It changed the name from "Spice" to "Spice-ETF" on Thursday to highlight the exact nature of the instrument. It has also issued a notice that clearly reiterates that the "theoretical price per unit is 1/100 of the Sensex value. Members are advised to place orders accordingly."

Much of the mispricing would disappear given more liquidity. Given the volumes normally generated by the underlying Sensex, liquidity could easily rise a thousand-fold.

But this would also require more awareness about the ETF concept. If ETFs work as they are intended to, these hybrids could be "killer apps". Sadly, the instruments haven't caught on in India yet!