Expanding MF reach

The industry has been abuzz with news of mutual funds being available through stock exchanges for transacting. UTI Mutual fund which was first to offer thirty schemes on NSE’s mutual fund service system received 300 applications and assets worth Rs 78 lakh. However, the recent rush of reforms has left investors confused whether mutual funds will become akin to Exchange traded funds (ETFs). We try to uncover the difference between the two.

The Securities Exchange Board of India (SEBI), in a circular issued on 13th November 2009, has mandated that the stock exchange terminals offer the facility to buy and sell schemes of mutual funds. SEBI states, “Units of mutual fund schemes may be permitted to be transacted through registered stock brokers of recognised stock exchanges and such stock brokers will be eligible to be considered as official points of acceptance.”

There are about 200,000 stock exchange terminals across 1,500 towns and cities. The move is expected to extend mutual funds to investors beyond the major metros and cities in India. Thus, the market regulator has opened up another channel for retail investors to buy or sell mutual funds using the existing stock exchange infrastructure.

However, this trade facility should not be confused with the Exchange Traded Funds (ETFs). Basically, ETFs are open-ended index funds listed on stock exchanges and were introduced in US in 1993. The assets under management of the global ETF industry stands at $711 billion at end of 2008 with a share of $1.28 billion from India (source Global ETF Research).

ETFs and mutual funds

 

ETFs allow exposure to different indices which reflect specific stocks, sectors, countries, fixed income or commodities. Mutual funds schemes have a specific investment objective based on which allocation to a particular asset or security is made. In fact, ETFs do not sell individual shares directly to investors and only issue their shares in large blocks (blocks of 50,000 shares, for example) that are known as “Creation Units.” (Source: Securities Exchange Commission). 
 

The portfolio composition of ETFs will be available to investors on a daily basis unlike mutual funds where you get to see a monthly factsheet. 
 

ETFs are traded on a real time basis which means that the prices change throughout the day as determined by the market forces while mutual funds have a Net Asset Value (NAV) at the end of each business day. The SEBI circular does not mention whether the NAV of mutual funds will fluctuate or be traded similar to ETFs. Presently, the units are allotted to investors based on previous day’s NAV or same day’s NAV in case the transaction is accepted before a particular cut-off time. 
 

ETFs can be purchased on margin and are lendable. Thus, ETFs are for a more sophisticated investor whereas mutual funds are an investment product for a retail investor. 
 

ETFs do not have sales load unlike the exit load in mutual funds. The expenses for ETFs are annual varying from 0.05 per cent and 1.60 per cent. Since August 2009 SEBI has abolished entry load for mutual funds. Also, there have been reports of SEBI’s advisory committee proposing to lower the fund management charges with increase in assets under management. 
 

Investors can sell their ETF shares in the secondary market, or sell the Creation Units back to the ETF. The purchase, sale or redemption of units in mutual funds always takes place between the investor and the Asset Management Company. 
 

ETFs work for institutional investors as an alternative to futures by establishing a short or a long position in the market. During bear markets, the most profitable investment strategy would be to short the market. However, retail investors of mutual funds would find it hard to benefit from bear markets – most of the retail equity funds provide long only exposure, meaning that investors of such funds benefit only when equity markets rise. Conversely, they will suffer losses when the equity markets plunge. Some of the equity funds with absolute return mandates or with mandates that allow for both long and short positions would be able to preserve the funds’ value slightly better than long only equity funds.

Exotic ETFs
In recent times, we also have ETFs that track fundamentals instead of market capitalisation. WisdomTree Investments, Inc. developed the first family of fundamentally-weighted indexes and ETFs. In contrast to capitalisation-weighted indexes, the WisdomTree Indexes anchor the initial weights of individual stocks to a measure of fundamental value.

The company believes its approach provides investors with a viable alternative to market capweighted indexes. To cite an example: the WisdomTree India Earnings Fund which holds assets of $526 million (as at 29 September 09), tracks the WisdomTree India Earnings Index, a fundamentally-weighted index. This index measures the performance of companies incorporated and traded in India that are profitable and that are eligible to be purchased by foreign investors as of the index measurement date. Companies are weighted in the index based on their earnings in the fiscal year prior to the Index measurement date, adjusted for a factor that takes into account shares available to foreign investors. For these purposes, “earnings” are determined using a company’s net income.

There are other exotic products like the iPath S&P500 VIX Short-Term Futures ETN, which is designed to provide exposure to equity market volatility through CBOE Volatility Index futures. Another exotic product, the iPath Global Carbon ETN, provides exposure to the performances of carbon credits.

Conclusion
ETFs and Mutual Funds fall into different segments in terms of investor profile. Mutual funds traded through stock exchange terminals are an additional avenue to transact for the retail investors. Clearly, this move by SEBI does not change the product attributes of mutual funds but in effect provides wider means of distribution.

The author is managing director, iFAST Financial India Pvt. Ltd. The views expressed are his own.