Indian Institute of Planning & Management

8/14/2019 Indian Institute of Planning & Management

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INDIAN INSTITUTE OF PLANNING &

MANAGEMENT(ESTD 1973)

New Delhi

Financial Services

Project Report

On

Comparison of: ETF & INDEX FUND

Submitted To :- Prof. Amit Bagga

Submitted by:

Amit mittal

Gurupreet singh sahni

Priyanka kohli

Sheenam chugh

Tania chaandwani

Fall Winter 2004-06

FN2

ETFs & INDEX FUNDS


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CONTENTS COVERED

Some exchange traded funds in India ETF in Indian context

Index funds

Advantages and Disadvantages

ETF in international arena

Difference b/w ETF and index fund

Tracking error

Which is beneficial for investing and how?

Some Exchange Traded Fund:


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NIFTY BeES an Exchange Traded Fund launched by BenchmarkMutual Fund in January 2002.

Junior BeES an Exchange Traded Fund on CNX Nifty Junior,launched by Benchmark Mutual Fund in February 2003.

SUNDER an Exchange Traded Fund launched by UTI in July 2003.

Liquid BeES an Exchange Traded Fund launched by BenchmarkMutual Fund in July 2003.

Bank BeES an Exchange Traded Fund (ETF) launched byBenchmark Mutual Fund in May 2004.

Benchmark Split Capital launched by Benchmark Mutual Fund onAugust 2005

Introduction

What do VIPERS, SPIDERS, WEBS, DIAMONDS and CUBES have incommon? Well, they are all Exchange Traded Funds. VIPERS stands forVanguard Index Participation Receipts), SPDRs is Standard & PoorsDepository Receipts, pronounced "SPIDERS"), CUBES is the name givenfor QQQ (called so because of its three 'Q's), and tracks thetechnology-laden NASDAQ 100 stocks. Also, they are a new addition tothe vocabulary of the Indian investor in the domestic financial marketsand a new species in the kingdom of the innovative financialinstruments that have become buzzwords in the turbulent stockmarkets. But ETFs are a novelty only in India. Exchange Traded Fundshave been in vogue in the global financial markets, especially the USfinancial markets for a long time now and have $110 billion locked inassets under management. An index of their popularity can be gaugedfrom the fact that about 60 per cent of the trading volumes on theAmerican Stock Exchange comes from ETFs.It is only now that thesefunds are catching on in the domestic mutual fund market in Inida. UTIhas launched its own ETF called SUNDERS, after Becnhmark's BeESand Prudential ICICI's SPIcE.

ETF: The History

Exchange Traded Funds came into existence in 1993 when, StateStreet Global Advisors, together with the American Stock Exchange,developed and launched the ETF market. The name of the product wasSPDRS. SPDR, which is benchmarked against the S&P 500 Index,continues to be the most successful product with over $22 billion inAssets Under Management. It currently enjoys tremendous liquidity,averaging close to $1 billion in shares changing hands every day onthe American Stock Exchange. In fact, it consistently ranks as one of
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the most active securities on the AMEX. In addition to launching theSPDR, State Street Global Advisors and the AMEX also launched theDow Diamonds in 1998, benchmarked against the Dow Jones IndustrialAverage. That year they also introduced the first sector ETFs, theSelect Sector SPDRs, benchmarked against the nine sectors making up

the S&P 500 Index. In 1999, they introduced the first ETF in Asia andcurrently they are doing the same in other major markets around theglobe. Now subsequent to the roaring success of the ETF market, moreand more complex instruments revolving around the ETFs are cominginto being. Such an innovation are options and futures on ETFs. OnNovember 18, 2002, EUREX (European Exchange) launched Europe'sfirst futures and options on the most liquid ETFs.

ETF: the concept explained

An Exchange Traded Fund, as the name itself suggests; is a financial

instrument, tradable on a stock exchange, that invests in the stocks ofan index in approximately the same proportion as held in the index. AnETF is a hybrid financial product, a cross between a stock and a mutualfund. Like a stock it can be traded on a stock exchange, and like amutual fund it behaves like a diversified portfolio. In many ways it is anindex fund, with a few subtleties that put it in a separate league. Unlikean open-ended index fund, where an investor purchases units from thefund itself and to redeem them sells the units back to the fund andthereby expanding or shrinking its corpus on each entry or exit fromthe fund, in an ETF is listed on an exchange ensuring that the entry orexit of investors has no effect on the fund corpus. An ETF is transacted

through a broker and held in dematerialized form. An ETF is differentfrom an Index Fund in another manner. Availability of real-time quotesis another feature present in an ETF but absent in an Index Fund wherethe previous days NAV is applied for buying or redeeming. This featuremakes the trading of the ETFs possible. Much like the units of a mutualfund the ETF too, is divided into units called a "creation unit". Thename emanates probably from the process through which one comesto acquire these units. The ETF units when purchased from the fundhouse are purchased by surrendering the underlying stocks in of theindex the ETF tracks and thereby 'creating' the ETF unit.

In short, they are similar to index mutual funds, but are traded morelike a stock. As their name implies, Exchange Traded Funds (ETFs)represent a basket of securities that are traded on an exchange. AnETF is a hybrid financial product, a cross between a stock and a mutualfund. Like a stock it can be traded on a stock exchange, and like amutual fund it behaves like a diversified portfolio. Unlike an open-ended index fund, where an investor purchases units from the funditself and to redeem them sells the units back to the fund and thereby


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expanding or shrinking its corpus on each entry or exit from the fund,in an ETF is listed on an exchange ensuring that the entry or exit ofinvestors has no effect on the fund corpus. An ETF is a combination ofan open-end and a close-end fund. Like any open-end fund, you canbuy units with the fund. But there is a difference. In an open-end fund,

you will pay cash to buy units. In the case of an ETF, you are requiredto provide the underlying shares to buy the units.

If the demand of the ETFs in the markets soars, the ETF would starttrading at a premium from its intrinsic value, which should be equal inproportion to the index that it is charting. This premium would makethe buyers go to the fund house where they would have to redeemtheir shares in the proportion held under each unit of the ETF. In caseof redemption in the market, the seller would get paid in cash and incase the fund units are taken to the issuer, the seller would get paid inkind that is the underlying shares that make up the index. ETF trading

also opens up the flood gates for some more complex tradingarrangements like arbitrage between the cash and futures market orsimply put - short selling. But there is a hitch as far as the Indiancapital markets is concerned: "shorting" is not allowed.

An ETF is basically created through an initial public offering (IPO) bythe Asset management companies in which only authorisedparticipants (Aps), institutions, large investors are allowed toparticipate. These investors exchange their portfolio of stocks and acash component for ETFs also known as creation units. Thesecreation units are made of two components namely portfolio deposit

and cash component. Portfolio deposit consists of basket of sharesthat make up an index and the cash component is the differencebetween the applicable NAV and the market value of the portfoliodeposit, which arises mainly due to transaction costs, rounding ofshares and incidental expenses involved. These units can be eitherheld as investments or sold in the market to the retail investors. ETFscan be also sold back to the mutual fund company but mutual fundsbuy it at a heavy discount to encourage their selling on the exchanges.The net asset value (NAV) of an ETF is the value of the underlyingcomponents of the benchmark index held by the ETF, plus the accrueddividends, less the accrued management fee.

How ETFs are tradedThe trading of the ETF is based on a well-known mechanism calledarbitrage. But first, let us see how one can buy an ETF. There are twoways in which one can buy an ETF. One is through the market and theother is through the fund house that has issued the ETF. Now for the


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pricing mechanism: if the demand of the ETFs in the markets soars, theETF would start trading at a premium from its intrinsic value, whichshould be equal in proportion to the index that it is charting. Thispremium would make the buyers go to the fund house where theywould have to redeem their shares in the proportion held under each

unit of the ETF. Such units that are bought directly from the fund houseare called "creation units". But usually the lot size in which one canbuy creation units is so high that only an authorized participant(market maker) or institutional investors may have the wherewithal tobuy these. In such case the retail investor would have to go to themarket itself to buy the units of the ETF, the decision in turn dependingon the expectations of the future price movements of the ETF. In caseof redemption in the market, the seller would get paid in cash and incase the fund units are taken to the issuer, the seller would get paid inkind that is the underlying shares that make up the index. ETF tradingalso opens up the flood gates for some more complex trading

arrangements like arbitrage between the cash and futures market orsimply put - short selling. But there is a hitch as far as the Indiancapital markets is concerned: "shorting" is not allowed. As a proxy, onecan borrow the units but that mechanism is not very efficient, as thecost of borrowing happens to range between 12 to 18 per centdepending on one's creditworthiness. Given below is a chart thatexplains the trading mechanism.


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Although ETFs are legally classified as open-end companies or UnitInvestment Trusts (UITs), they differ from traditional open-endcompanies and UITs in the following respects:

ETFs do not sell individual shares directly to investors and only

issue their shares in large blocks (blocks of 50,000 shares, forexample) that are known as "Creation Units." Investors generally do not purchase Creation Units with cash.

Instead, they buy Creation Units with a basket of securities thatgenerally mirrors the ETFs portfolio. Those who purchaseCreation Units are frequently institutions.

After purchasing a Creation Unit, an investor often splits it upand sells the individual shares on a secondary market. Thispermits other investors to purchase individual shares (instead ofCreation Units).

Investors who want to sell their ETF shares have two options: (1)

they can sell individual shares to other investors on thesecondary market, or (2) they can sell the Creation Units back tothe ETF. In addition, ETFs generally redeem Creation Units bygiving investors the securities that comprise the portfolio insteadof cash. So, for example, an ETF invested in the stocks containedin the Dow Jones Industrial Average (DJIA) would give aredeeming shareholder the actual securities that constitute theDJIA instead of cash. Because of the limited redeemability of ETFshares, ETFs are not considered to beand may not callthemselvesmutual funds.

An ETF, like any other type of investment company, will have aprospectus. All investors that purchase Creation Units receive aprospectus. Some ETFs also deliver a prospectus to secondary marketpurchasers. ETFs that do not deliver a prospectus are required to giveinvestors a document known as a Product Description, whichsummarizes key information about the ETF and explains how to obtaina prospectus.

All ETFs will deliver a prospectus upon request. ETFs do not useprofiles. ETFs that are legally structured as open-end companies (butnot those that are structured as UITs) must also have statements of

additional information (SAIs). Open-end ETFs (but not UIT ETFs) mustprovide shareholders with annual and semi-annual reports.

Advantages Of Exchange-Traded Funds

It was State Street Global Advisors who launched the first exchange-traded fund (ETF) in 1993 with the introduction of the SPDR. Since
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then, ETFs have continued to grow in popularity but also gather assetsat a rapid pace. The easiest way to understand ETFs is to think of themas mutual funds that trade like stocks. Of course, trading like a stock isjust one of the many features that make ETFs so popular. Let's go overthese attractive features.

Tradable and Diversifiable:The ultimate selling proposition ofan ETF lies in its twin feature of being tradable and diversifiable.One can trade a stock but then it is not diversifiable. Or, one canbuy a mutual fund and thereby diversify but then the mutualfund would not be tradable. Alternatively, one can diversify one'srisks by holding a portfolio of stocks and trade them but thatwould be too much of a botheration for the lay investor. Thisconflicts are reconciled by an ETF that is at once tradable and isa diversified portfolio too. It is these two feature, working intandem, like the twin blades of a scissor that make it a financial

product of choice. Low cost: Just like an Index-Fund an Exchange Traded Fund

does not have to incur any costs on account of active fundmanagement because the fund is passively managed. As theETFs are listed on the exchange, the cost of distribution is low.Furthermore, exchange traded mechanism reduces minimalcollection, disbursement and other processing charges.

Transparency: Just like the index fund, the portfolio of an indexfund has no mystery to it. Everybody in the participating marketis aware of the stocks that it is tracking and therefore need notworry about a change in the stocks being traded in.

Makes multiple trading strategy possible: As has been saidearlier, ETFs have the utility of doubling up as arbitraginginstruments between the futures and cash markets. It also helpsin equitizing cash, i.e., changing cash into equities, at a low cost.

A Bear market friend: In a volatile stock market, an ETF mightbecome an instrument of choice as it is not expected to be asvolatile and yet may be traded. This is borne out by the fact thatthe assets of US ETFs have grown from $ 96 billion in January2003 to $118 billion in May 2003.

ETFs can be bought and sold throughout the trading day,allowing for intraday trading - which is rare with mutual funds.

Traders have the ability to short or buy ETFs on margin.

Low annual expenses rival the cheapest mutual funds.

Arbitrage between Futures and Cash market

No separate form filling. A phone call to a broker or a click on thenet is needed.

Ability to put limit orders

Minimum investment is one unit
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The Benefits of Trading Like a Stock The easiest way tohighlight the advantage of the ETF trading like a stock is tocompare it to the trading of a mutual fund. Mutual funds arepriced once per day, at the close of business. Everyonepurchasing the fund that day gets the same price, regardless of

the time of day their purchase was made. Because, liketraditional stocks and bonds, ETFs can be traded intraday, theyprovide an opportunity for investors to bet on the direction ofshorter-term market movements through the trading of a singlesecurity. For example, if the S&P 500 is experiencing a steep risein price through the day, investors can try to take advantage ofthis rise by purchasing an ETF that mirrors the index (such as aSPDR), hold it for a few hours while the price continues to riseand then sell it at a profit before the close of business. Investorsin a mutual fund that mirrors the S&P 500 do not have thiscapability - by nature of the way it is traded, a mutual fund does

not allow investors to take advantage of the daily fluctuations ofits basket of securities.The ETF's stock-like quality allows the investor to do more thansimply trade intraday. Unlike mutual funds, ETFs are also forspeculative trading strategies, such as short selling and tradingon margin. In short, the ETF allows investors to trade the entiremarket as though it were one single stock.

Low Expense Ratios Everybody loves to save money,particularly investors who take their savings and put them towork in their portfolios. In helping investors save money, ETFsreally shine. They offer all of the benefits associated with index

funds - such as low turnover and broad diversification (not tomention the often-cited statistic that 80% of the moreexpensive actively managed mutual funds fail to beat theirbenchmarks) - plus ETFs cost a lot less. Compare the Vanguard500 Index Fund, often cited as one of the lowest of the low-costindex funds, and the SPDR 500 ETF. The Vanguard fund'sexpense ratio of 18 basis points is significantly lower than the100+ basis points often charged by actively managed mutualfunds. But when compared to the SPDR's 11-basis-point expenseratio, the Vanguard fund's expense ratio looks quite high. In factthe SPDR is 40% lower, which is tough to argue with.Do keep in

mind, however, that because ETFs trade through a brokeragefirm, each trade incurs a commission charge. To avoid lettingcommission costs negate the value of the low expense ratio,shop for a low-cost brokerage (trades under $10 are notuncommon) and invest in increments of $1,000 or more.

Diversification ETFs come in handy when investors want tocreate a diversified portfolio. There are hundreds of ETFs
http://www.investopedia.com/terms/m/mutualfund.asphttp://www.investopedia.com/articles/mutualfund/05/060605.asp#%23http://www.investopedia.com/terms/i/intraday.asphttp://www.investopedia.com/articles/mutualfund/05/060605.asp#%23http://www.investopedia.com/terms/s/sp500.asphttp://www.investopedia.com/terms/s/shortselling.asphttp://www.investopedia.com/terms/i/indexfund.asphttp://www.investopedia.com/terms/i/indexfund.asphttp://www.investopedia.com/terms/t/turnover.asphttp://www.investopedia.com/terms/d/diversification.asphttp://www.investopedia.com/terms/a/activemanagement.asphttp://www.investopedia.com/terms/e/expenseratio.asphttp://www.investopedia.com/terms/b/basispoint.asphttp://www.investopedia.com/terms/m/mutualfund.asphttp://www.investopedia.com/articles/mutualfund/05/060605.asp#%23http://www.investopedia.com/terms/i/intraday.asphttp://www.investopedia.com/articles/mutualfund/05/060605.asp#%23http://www.investopedia.com/terms/s/sp500.asphttp://www.investopedia.com/terms/s/shortselling.asphttp://www.investopedia.com/terms/i/indexfund.asphttp://www.investopedia.com/terms/i/indexfund.asphttp://www.investopedia.com/terms/t/turnover.asphttp://www.investopedia.com/terms/d/diversification.asphttp://www.investopedia.com/terms/a/activemanagement.asphttp://www.investopedia.com/terms/e/expenseratio.asphttp://www.investopedia.com/terms/b/basispoint.asp


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available, and they cover every major index (those issued byDow Jones, S&P, Nasdaq) and sector of the equities market (largecaps, small caps, growth, value). There are international ETFs,regional ETFs (Europe, Pacific Rim, emerging markets) andcountry-specific (Japan, Australia, U.K.) ETFs. Specialized ETFs

cover specific industries (technology, biotech, energy) andmarket niches (REITs, gold). And ETFs cover also other assetclasses, such as fixed income. While ETFs offer fewer choices inthe fixed-income arena, there are still plenty of options, includingETFs composed of long-term bonds, mid-term bonds and short-term bonds. While fixed-income ETFs are often selected for theincome produced by their dividends, some equity ETFs also paydividends. These payments can be deposited into a brokerageaccount or reinvested. If you invest in a dividend-paying ETF, besure to check the fees prior to reinvesting the dividends, as somefirms offer free dividend reinvestment, while others do not.

Studies have shown that asset allocation is a primary factorresponsible for investment returns, and ETFs are a convenientway for investors to build a portfolio that meets specific assetallocation needs. For example, an investor seeking an allocationof 80% stocks and 20% bonds can easily create that portfoliowith ETFs. That investor can even further diversify by dividingthe stock portion into large-capgrowth and small-capvaluestocks, and the bond portion into mid-term and short-termbonds. Or, it would be just as easy to create an 80/20 bond-to-stock portfolio that includes ETFs tracking long-term bonds andthose tracking REITs. The large number of available ETFs enables

investors to quickly and easily build a diversified portfolio thatmeets any asset allocation model.

Tax Efficiency ETFs are a favorite among tax-aware investorsbecause the portfolios that ETFs represent are even more taxefficient than index funds. In addition to offering low turnover - abenefit associated with indexing - the unique structure of ETFsenables investors trading large volumes (generally institutionalinvestors) to receive in-kind redemptions. This means that aninvestor trading large volumes of ETFs can redeem them for theshares of stocks that the ETFs track. This arrangement minimizestax implications for the investor exchanging the ETFs since the

investor can defer most taxes until the investment is sold.Furthermore, you can choose ETFs that don't have large capitalgains distributions or pay dividends (because of theparticular kinds of stocks they track).

Summary The reasons for the popularity of ETFs are easy tounderstand. The associated costs are low, and the portfolios areflexible and tax efficient. This simple, convenient combination
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results in an investment that some people believe will one dayreplace traditional mutual funds in most investor's portfolios.

Disadvantages of ETFs

Unfortunately, exchange traded funds do have some negatives:

Absence of prior active market: In India ETFs being a newinstrument, there is no existing market that one could swim intoimmediately after buying the product. So for the liquidity to bereasonable, a large number of investors would have to buy intothe idea to make adequate liquidity possible.

Large Investments: In order to deal directly with the fundhouses large capital investments are required. For example inthe case of Nifty BeES, a minimum creation unit size of 20000units is required that would involve lakhs of rupees ininvestment. This makes ETFs a market where the institutionalbuyers and sellers become the big fish.

Broker Charges: Broker charges have to be paid anyway whentrading in ETFs. This can be minimized by trading long but thevery charm of ETFs is destroyed because it is meant for beingtraded more often than an index fund.

Premiums and discounts: An ETF might trade at a discount tothe underlying shares. This means that although the sharesmight be doing very well on the bourses, yet the ETF might betraded at less than the market value of these stocks.

Does not facilitate "rupee cost averaging": An ETF is notappropriate for those investors who want to operate on thestrategy of"rupee cost averaging". This is because investorsinvesting some money into ETFs every month would have toincur brokerage costs that are not to be incurred in case ofmutual fund units until and unless the scheme carries an entryload.

Unlike mutual funds, ETFs don't necessarily trade at the netasset values of their underlying holdings, meaning an ETF couldpotentially trade above or below the value of the underlyingportfolios.

Slippage - as with stocks, there is a bid-ask spread, meaning youmight buy the ETF for 15 1/8 but can only sell it for 15 (which isbasically a hidden charge).

The Role of Arbitrage in ETFs
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Critics of ETFs often cite the potential for ETFs to trade at a share pricethat is not aligned with the value of the underlying securities. To helpus understand this concern, a simple representative example best tellsthe story.

Assume an ETF is made up of only two underlying securities:

Security A, which is worth $1 per share Security B, which is also worth $1 per share

In this example, most investors would expect one share of the ETF totrade at $2.00 per share (the equivalent worth of Security A andSecurity B). While this is a reasonable expectation, it is not always thecase. It is possible for the ETF to trade at $2.02 per share or $1.98 pershare or some other value.

If the ETF is trading at $2.02, investors buying shares of the ETF arepaying more for the shares than the underlying securities are worth.This would seem to be a dangerous scenario for the average investor,but in reality, it isn't a major problem because ofarbitrage trading.

Here's how arbitrage sets the ETF back into equilibrium. The tradingprice of an ETF is established at the close of business each day, justlike any other mutual fund.ETF sponsors also announce the value of the underlying shares on adaily basis. When the price of the ETF deviates from the value of theunderlying shares, the arbitragers spring into action. If the underlying

securities are trading at a lower price than the ETF shares, arbitragersbuy the underlying securities, redeem them for creation units, andthen sell the ETF shares on the open market for a profit. If underlyingsecurities are trading at higher values than the ETF shares, arbitragersbuy ETF shares on the open market, form creations units, redeem thecreation units in order to get the underlying securities, and then sellthe securities on the open market for a profit.The actions of the arbitragers set the supply and demand of the ETFsback into equilibrium to match the value of the underlying shares.

Because ETFs were used by institutional investors long before they

were discovered by the investing public, active arbitrage amonginstitutional investors has served to keep ETF shares trading at a rangethat is close to the value of the underlying securities.

End ResultIn a sense, ETFs have a lot in common with wrist watches. Everybodywants their watch to tell the correct time, but they don't need to know
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how the watch was built in order to benefit from it. With ETFs,investors can enjoy the benefits associated with this unique andattractive investment product, without even being aware of thecomplicated series of events that make it work. But, of course, knowinghow those events work makes you a more educated investor, which is

the key to being a better investor.

If you have longer time horizons and larger, lump-sum amounts, youmay want to consider ETFs over index funds if you are investing in ataxable account.

ETFs tend to generate fewer capital gains than mutual funds due to thelow turnover of the securities that comprise them, and because theyare not required to sell securities to meet investor cash redemptions.Keep in mind, however, that you will generate taxable capitalgains/losses if you sell the ETF shares.

Investment Applications

ETFs can be used as:

Long term core holding - Due to its lower cost and ability toinsulate long-term holders from short-term traders makes it idealcore holdings for small to large investors.

Diversification for small amounts - One can buy even oneshare of nifty ETFs lower for lower than Rs. 200 for gettingexposure in large cap 50 stocks in one go.

Short term tactical play - ETFs are ideal for top downinvestors to implement there near term views for either broaderequity markets or sectors.

Equitising cash for new flows or restructuring the

portfolio - Many institutions before they invest in individualstocks can use ETFs to get broad market exposure in order to aunderperformance.

Arbitrage with futures - One can use ETFs to make profit outof pricing anomalies of the future pricing if any.

For writing covered index calls. Delta hedging for index options.

Which Is Right for Investing?

Generally speaking, if you are a long-term investor making smaller,periodic investments, you may want to consider traditional indexfunds over ETFs, because index funds can be purchased with notransaction commissions.


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Longer-term short position (Difficult currently due very fewstock borrowers and lenders)

Short term tactical play - ETFs are ideal for top downinvestors to invest in short term.

Right now six ETFs are operating in the Indian mutual funds Industry.Out of these Benchmark Mutual Fund manages four ETFs. Benchmarkwas the first in India, which came up with an ETF called Nifty BeES inJanuary 2002. The other two are from Prudential ICICI Mutual Fund andUTI Mutual Fund. The performance of the ETFs is mentioned below.

Performance as on July 29, 2005

Absolute Absolute

Scheme Name6

Months

1Year

Benchmarks

6Month

s1 Year

Bank BeES 32.06 87.01 CNXBankex

17.99 85.45

Junior BeES 17.93 60.77CNX Nifty

Junior17.10 59.61

Nifty BeES 13.76 42.20 S&P Nifty 15.14 42.85S&P CNX NIFTY UTINational DepositoryReceipts Scheme

15.12 43.95 S&P Nifty 15.14 42.85

SENSEX Prudential ICICIExchange Traded Fund

19.34 49.00 Sensex 18.95 49.12

Another ETF doing the rounds is the Gold Exchange Traded Fund(GETF), something that the Finance Minister P Chidambaram touchedin his budget speech this year. UTI Mutual Fund is believed to be toyingwith the idea of launching a Gold fund, in which the investor will beallowed to convert gold ornaments into tradable units and get returnson it.

What Is an Index?

Index funds are mutual funds that attempt to copy the performance of

a stock market index. The most common index fund tries to track theS&P 500 by purchasing all 500 stocks using the same percentages asthe index. Other indices that mutual funds try to copy include: Russell2000, Wilshire 5000, MCSI-EAFE, Lehman-Brothers Aggregate Bond,and NASDAQ 100.

Most indexes are a collection of securities that provide a statisticalmeasure of a market or a subset of a market. The earliest indexes


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were designed to gauge the market's general direction. For example,the Dow Jones Industrial Average (DJIA) was created in 1896 byCharles Dow and originally tracked the performance of 12 large U.S.stocks. The DJIA, like the S&P 500 and Wilshire 5000, now serves asa benchmark of how well all stocks on the American markets perform

each day.

How Indexes WorkWhether an index was created to gauge the performance of themarket, or as a benchmark to measure the performance of aninvestment manager, most indexes are comprised of securities. Someindexes use objective and transparent rules to determine theirconstituent securities, while others are more subjective.Reconstitution, or the periodic rebalancing of an index, is importantbecause security characteristics change over time.

For example, a small cap security can grow into a mid cap over time.The timing of reconstitution is important, because it allows for closemirroring of the market. Indexes need to be reconstituted regularly;too frequent reconstitution, however, can result in turnover costs forinvestors.

Over the long haul, it's pretty tough to beat the market, whichhistorically has churned out average annual returns of about 10%. Inthe "If you can't beat 'em, join 'em" spirit, index funds were created.

Index mutual funds aim to match the performance of a securities indexby purchasing shares of all or nearly all of the stocks in that particularindex. The granddaddy of all index funds (and still the biggest indexfund), the Vanguard 500 Index, was created in 1976 for investors totrack the performance of the S&P 500, a broad index that lists 500large companies from a cross-section of sectors. Since then, indexfunds have cropped up that mirror just about every index out there:small-cap indices, sector indices, you name it. Indeed, there are even"enhanced" index funds that try to slightly exceed the performance ofa given benchmark, but that isn't always easy to do. (Another growingsegment of index funds are exchange-traded funds .)

Because the aim of most index funds is merely to mirror an index'sperformance, the funds aren't actively managed. This means themanagement fees are typically far less expensive than most mutualfunds. Their relatively low cost is a key factor in their popularity.

Keep in mind that index funds don't try to set the world on fire, theyonly want to match an index. If the benchmark index goes up about
http://quote.thestreet.com/cgi-bin/texis/protected/FundQuotes?tkr=VFINXhttp://www.thestreet.com/basics/gettingstarted/995866.htmlhttp://quote.thestreet.com/cgi-bin/texis/protected/FundQuotes?tkr=VFINXhttp://www.thestreet.com/basics/gettingstarted/995866.html


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10% for the year, so does the index fund. If the benchmark declines10% for the year, so does the index fund.

While the first index fund and other early index funds tried to matchindices such as the S&P 500 that represented a fairly broad swath of

the market, more recent index fund offerings, such as the Internetindex funds, are pretty concentrated, and shouldn't be construed as adiversification strategy.

Like all investment vehicles, indexing has its proponents and itsdetractors. Whether it works for you depends on what you want out ofyour portfolio. Want to swing for the fences and take on some risk in abid to beat the pack? Try an actively managed fund. Want to "join'em," and be content with matching the index of your choice? Look nofurther.

Key Differences Between ETFs and Index Funds

ETFs

Index Funds

Shares can be bought and sold atintra-day market prices on anexchange. If permitted by yourbroker, shares on the secondarymarket can be bought on marginor by limit order, and may be sold

Shares can be bought and solddirectly from the fund at a netasset value set once per day,typically at 4 p.m. ET. Index fundsgenerally cannot be sold short orbought on margin.


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short subject to exchange rules.

Generally have lower expensesthan traditional mutual funds(even index funds) and may havesome tax efficiencies at the fundlevel.

Tend to have lower expenses thantraditional mutual funds.

When buying shares in thesecondary market, there are noinvestment minimums (i.e., youcan purchase a single share) or

sales charges other than the costof a stock transaction.

Investment minimums can vary byfund, and fund shares can beeither load or no-load.

Rapid trading in the secondarymarket by other investors doesnot create costs for othershareholders, and since the priceis set throughout the day by themarket, there is no opportunity forlate trading.

Rapid trading by other investorscan create costs for othershareholders since the fundmanager must have cash on hand(or sell shares of securities togenerate cash) to satisfyredemptions.

Shares are not individuallyredeemable from the fund.Instead they must be sold on thesecondary market.

Shares are individuallyredeemable from the fund.

Shares are sold on the secondarymarket at market value, whichmay be less than NAV. There areno sales loads, however,transactions on the secondarymarket are subject to brokeragecommissions.

Shares are redeemed at NAV.

Following points distinguish ETFs from the index funds:

POINTS Exchange traded funds Index Funds

Intra-day YES NO


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Trading

Tax Efficiency YES NO

Low expenseRatio

YES NO

Brokerage YES NOReal TimeQuotes

YES End of the Day

Tracking error LESS More

Liquidity Risk MORE NIL

Short Facility YES NO

Load Not applicable unless redeemed tomutual funds

Either Entry or Exitload

How ETFs work?

ETFs are securities certificates that state legal right of ownership overpart of a basket of individual stock certificates. Several different kindsof financial firms are needed for ETFs to come into being, trade atprices that closely match their underlying assets, and unwind wheninvestors no longer want them. Laying all the groundwork is the fundmanager. This is the main backer behind any ETF, and they mustsubmit a detailed plan for how the ETF will operate to be given

permission by the SEC to proceed.

In theory all that a fund manager needs to do is establish clearprocedures and describe precisely the composition of the ETF (whichchanges infrequently) to the other firms involved in ETF creation andredemption. In practice, however, only the very biggest institutionalmoney management firms with experience in indexing tend to play thisrole, such as The Vanguard Group and Barclays Global Investors. Theydirect pension funds with enormous baskets of stocks in markets allover the world to loan stocks necessary for the creation process. Theyalso create demand by lining up customers, either institutional or

retail, to buy a newly introduced ETF.

The creation of an ETF officially begins with an authorized participant,also referred to as a market maker or specialist. Highly scrutinized fortheir integrity and operational competence, these middlemenassemble the appropriate basket of stocks and send them to aspecially designated custodial bank for safekeeping. These baskets arenormally quite large, sufficient to purchase 10,000 to 50,000 shares of


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the ETF in question. The custodial bank doublechecks that the basketrepresents the requested ETF and forwards the ETF shares on to theauthorized participant. This is a so-called in-kind trade of essentiallyequivalent items that does not trigger capital gains for investors.

The custodial bank holds the basket of stocks in the fund's account forthe fund manager to monitor. There isn't too much activity in theseaccounts, but some cash comes into them for dividends and there area variety of oversight tasks to perform. Some managers have leewayto use derivatives to track an index.

This flow of individual stocks and ETF certificates goes through theDepository Trust Clearing Corp., the same US government agency thatrecords individual stock sales and keeps the official record of thesetransactions. It records ETF transfer of title just like any stock. Itprovides an extra layer of assurance against fraud.

Once the authorized participant obtains the ETF from the custodialbank, it is free to sell it into the open market. From then on ETF sharesare sold and resold freely among investors on the open market.

Redemption is simply the reverse. An authorized participant buys alarge block of ETFs on the open market and sends it to the custodialbank and in return receives back an equivalent basket of individualstocks which are then sold on the open market or typically returned totheir loanees.

What motivates each player? The fund manager takes a small portionof the fund's annual assets as their fee, clearly stated in theprospectus available to all investors. The investors who loan stocks tomake up a basket make a small interest fee for the favor. The custodialbank makes a small portion of assets likewise, usually paid for by thefund manager out of management fees. The authorized participant isprimarily driven by profits from the difference in price between thebasket of stocks and the ETF and on part of the bid-ask spread of theETF itself. Whenever there is an opportunity to earn a little by buyingone and selling the other, the authorized participant will jump in.

The process might seem cumbersome but it does allow fortransparency and liquidity at modest cost. Everyone can see what goesinto an ETF, investor fees are clearly laid out, investors can beconfident that they can exit at any time, and even the authorizedparticipant's fees are guaranteed to be modest. If one allows ETFprices to deviate from the underlying net asset value of the componentstocks, another can step in and take profit on the difference, so their


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competition tends to keep ETF prices very close to it underlying NetAsset Value (value of component stocks).

Why Exchange Traded Funds?

Exchange-Traded Funds, or ETFs, are index funds that trade just likestocks on major stock exchanges. Want to invest in the market quicklyand cheaply? ETFs are the most practical vehicle. They help theinvestor focus on what is most important, choice of asset classes.

All the major stock indexes including world stock exchanges have ETFsbased on them, including:

Dow Jones Industrial Average

Standard & Poor's 500 Index

Nasdaq Composite

There are ETFs for large US companies, small ones, real estateinvestment trusts, international stocks, bonds, and even gold. Pick anasset class that is publicly available and there is a good bet that it isrepresented by an ETF or will be soon.

ETFs differ fundamentally from traditional mutual funds, which do nottrade midday. Traditional mutual funds take orders during Wall Streettrading hours, but the transactions actually occur at the close of themarket. The price they receive is the sum of the closing day prices ofall the stocks contained in the fund. Not so for ETFs, which tradeinstantaneously all day long and allow an investor to lock in a price forthe underlying stocks immediately.

ETFs are economical to buy and especially to maintain over the long-run, making them especially attractive for the typical buy-and-hold

investor. Annual fees are as low as .09% of assets, which isbreathtakingly low compared to the average mutual fund fees of 1.4%.Although investors must pay a brokerage transaction to purchasethem, with discount brokers this becomes negligible with sizabletrades. There are a few easy-to-avoid pitfalls to watch out for. Taxeffects are also not to be ignored, and ETFs perform well after-tax.They can be margined, and options based on them allow for variousdefensive (or speculative) investing strategies.


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Their safety as a securities instrument (considered separately from thesafety of any particular asset class they might represent) is consideredthe same as stock certificates themselves. Internally, ETFs are farmore complex entities than mutual funds. A fascinating combination ofplayers, including brokers, money managers and market specialists

combine to make them run smoothly. Legally, ETFs are a class ofmutual fund as they fall under many of the same Securities ExchangeCommission rules that traditional mutual funds do. But their differentstructure means that the SEC has imposed different requirements fromtraditional mutual funds in how they are bought and sold.

ETFs are index funds at heart, so investors are encouraged to studythe philosophy of index investing which downplays stock picking infavor of buying the market. But unlike most traditional index funds,investors need not take a passive, buy-and-hold approach. ETFs arealso becoming favorites of hedge funds and day traders who like to pull

the trigger frequently. Both types of investors may coexist and in factstrengthen each other by lowering overall transaction costs.

ETF Liquidity Myth Dispelled

We thought it was time to put a common misconception on exchange-traded fund liquidity to rest.

Some investors appear to believe that the liquidity of an ETF isdependent on the fund's average trading volume, or the number ofshares traded per day. However, this is not the case. Rather, a better

measure of ETF liquidity is the liquidity of the underlying stocks in theindex. Understanding this fact requires a brief look into how ETFsfunction on a basic level.

Since ETFs trade like stocks, market makers (also called authorizedparticipants or APs) are the folks that order the creation andredemption of ETF shares. Market makers build an ETF share from theshares of the companies in the underlying index. They create orredeem shares depending on the market demand for the ETF shares.

It should also be noted that market makers and specialists can create

and redeem shares to arbitrage premiums or discounts to theunderlying net asset value (NAV). This activity is beneficial to ETFinvestors because it keeps the price of the fund in line with the NAVand prevents specialists from making unfair markets. Think of it as amechanism that ensures retail investors like us will get a fair price asthe APs step all over each other trying to make a buck. Pretty neat,huh?


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Large brokerage houses such as Morgan Stanley and Salomon SmithBarney also occasionally act as authorized participants when a clientmakes a large order. Based on their ability to purchase the underlyingstocks in the ETF, they can create a huge number of ETF sharesinstantly with little difficulty in a liquid index like the S&P 500. In

essence, there is enormous liquidity in ETFs based on popular indexes -the AP just has to turn on the hose.

Not surprisingly, ETFs based on indexes that also have derivatives tiedto them have even slimmer bid-ask spreads. The reason is that there isheightened interaction between the specialists, market makers, andarbitrageurs. In other words, ETF shareholders benefit from thisincreased competition because it narrows spreads. For example, StateStreet Global Advisors recently reported that the average bid-askspread calculated over 160 days on SPDR 500 (AMEX:SPY - News) was0.09%. More firms are researching ETF bid-ask spreads, and the results

confirm that ETFs tied to liquid indexes have very small spreads.

Investors with a healthy apocalypse complex might notice here that anETF's liquidity could dry up in severe market conditions. This did in facthappen with a Malaysian basket of stocks after that country institutedcurrency controls. We don't mean to harp on this fact, but investorsshould at least be aware of this bit of ETF history.

However, if you have confidence in U.S. market liquidity then youshould feel safe using existing broad-based domestic ETFs, and theirhistory thus far bears that out. We would add that a wait-and-see

attitude could be beneficial for potential ETFs tied to illiquid indexes -private securities or municipal bonds, for example.

To quantify ETF liquidity, Salomon Smith Barney has conducted several"snapshot studies" that take random pictures of the ETF market to lookat bid-ask spreads of domestic and international ETFs. Below are theresults of the latest snapshot study conducted in January 2002, whenSalomon Smith Barney gathered data from 40 random snapshots takenthroughout the month.

Domestic ETFs

Average bid61,752shares

Average ask66,799shares

Average spread $0.18

Average spread % 0.330%
http://finance.yahoo.com/q?s=spy&d=thttp://finance.yahoo.com/q/h?s=spyhttp://finance.yahoo.com/q?s=spy&d=thttp://finance.yahoo.com/q/h?s=spy


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Cap-weighted avg.spread

$0.06

Cap-weighted avg.spread %

0.087%

Source: Salomon Smith Barney, Bloomberg, the AMEX

International ETFs

Average bid13,487shares

Average ask15,438shares

Average spread $0.19

Average spread % 0.867%Cap-weighted avg.spread

$0.17

Cap-weighted avg.spread %

0.591%

Source: Salomon Smith Barney, Bloomberg, the AMEX

Salomon also looked at premiums and discounts for the domestic andinternational ETFs. The tables below show that that the premiums and

discounts for ETFs are very small. Not surprisingly, the internationalETFs have larger premiums and discounts because the stocks are notas accessible.

Domestic ETF Snapshot study -Premiums/Discounts

Bid P/D Mid P/D Ask P/D

Average-0.0937%

0.0067% 0.1069%

Maximum 1.4550% 1.6430% 3.5760%

Minimum-1.2110%

-0.7010%

-0.5810%

Cap-weighted avg.-0.0006%

-0.0028%

-0.0050%

Source: Salomon Smith Barney, Bloomberg


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International ETF Snapshot study -Premiums/Discounts

Bid P/D Mid P/D Ask P/D

Average-

0.4753%-0.0469% 0.3815%

Maximum 2.4603% 2.7778% 3.0952%

Minimum-3.8961%

-3.3575% -2.9520%

Cap-weighted avg.-0.3066%

-0.0110% 0.2846%

Source: Salomon Smith Barney, Bloomberg

The analysts who wrote the report noted that the results improvedramatically each time they conduct the snapshot study. They alsosaid the growth in popularity of ETFs has helped shrink spreads,although the growth in the number of smaller funds has probably hadan adverse affect on the overall results.

Additionally, a very competitive market was established in theVanguard Total Stock Market Vipers (AMEX:VTI - News). The managersof other broad-based competitor ETFs have countered by shrinkingspreads in their own funds, according to Salomon Smith Barney.

Finally, the New York Stock Exchange is trading several AMEX-listedETFs, and the addition of more specialists has created increasedcompetition and helped reduce spreads even further.

Tax Advantages with ETFs

As luck would have it ETFs are also quite tax-efficient. Because of theway they are created and redeemed, they allow an investor to paymost of his capital gains upon final sale of the ETF, delaying it until thevery end. There is no way to avoid capital gains, but delaying it isvaluable because the amount that would have been paid to taxes can

continue to accumulate wealth. Exactly how much an investor benefitsafter-tax depends on their marginal tax rate, the return of theinvestment, and how long they hold the investment. Overall, ETFs aresimilar to tax managed index mutual funds, slightly more efficient thanstandard mutual funds, and significantly more efficient than activelymanaged mutual funds.
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Traditional mutual funds accumulate unrealized capital gains liabilitiesfor stocks that have risen in value. Upon sale of these stocks the fundcalculates and periodically distributes the capital gains to its investorsin proportion to their ownership. The following table illustrates acomparison of ETFs versus standard index mutual funds:

Capital Gains Distributions as a Percentage of Assets, August 2000-August 2001

Index tracked ETFIndex MutualFund

S&P 5000.05%

0.00%

S&P MidCap 4000.30%

8.54%

Russell 20000.17%

13.64%

S&P 500/Barra Value0.24%

6.53%

S&P SmallCap 600/BarraValue

0.44%

7.13%

S&P 500/Barra Growth0.16%

0.00%

S&P SmallCap 600/Barra

Growth

0.81

%5.24%

Average0.31%

5.87%

(Source: Bloomberg, from May, 2002 issue of Financial PlanningMagazine)

Both types of funds in the table have modest distributions, certainly incomparison to actively managed mutual funds. And the more turnoverfrom trying to pick stocks, the more an active fund will force investors

to pay the IRS. It's an ugly and little discussed fact that active mutualfund investors can end up paying other investors' tax bills, especially ina bear market. That's because investors who sell out before the day ofrecord for that distribution will not receive the tax bill, while loyalinvestors who stay in will pay it for the entire amount!

How is it ETFs are so efficient? Through a regulatory loophole, ETFs areconsidered to be created by trading equivalent certificates (the ETF for


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the many stocks that make up the basket) in what is called an in-kindtrade. This exchange of essentially identical items does not triggercapital gains, according to the IRS. Traditional mutual funds must gointo the open market and exchange cash for stocks and vice versa,which trigger realization of gains. It's a subtle difference, admittedly,

but which results in an advantage for the ETF investor.

As always, there are exceptions. Occasionally an ETF fund that is onlya few years old may throw off unusually high distributions, in a marketdownturn. But this is atypical.

Asset Allocation with ETFs

The importance of asset allocation, or deciding what percentage of aportfolio to devote to various asset classes, cannot be overstated.Investors spend enormous amounts of time and money picking

individual stocks, while they spend relatively little deciding what typesof stock or bond to their funds. It should be just the opposite.

Investors should spend most of their time on overall asset selectionand ignore individual stocks for the most part. Repeated studies(1) byunbiased university researchers have shown that about 95% of moneymanagers' performance, for better or worse, can be explained by theirselection of asset classes, not by their selection of individual stocks.When a stock performs well, invariably stocks from the same assetclasses follow in parallel. All one has to do is pick asset classes well tooutperform. Asset allocation is not necessarily easy, but it is less

detailed and time consuming than stock picking, and it rewards thediligent investor handsomely.

Why is stock picking so unproductive? Most economists feel this isbecause of the enormous competition in the markets. So many expertsare analyzing stocks that there is no public information others have notexamined and acted on. Insider information probably would give anadvantage but it is, of course, illegal to use for trading. The sheer costof sifting through information about individual companies raises thehurdle further for stock picking funds to beat the market. One strategyto avoid the crush of competition is to gravitate to lesser-known

companies, but this brings with it higher risk. The record clearly showsthat on average stock picking funds do not beat the market, and thereis no evidence that stock pickers who are initially successful canmaintain their edge over time.

Happily, ETFs are the ideal tool for the investor focused on assetallocation. They represent just about every asset class available and


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are cheap, liquid, and reliable. The primary asset classes in which ETFsare available include:

Large Cap Stocks

Mid Cap Stocks

Small Cap Stocks

Growth Stocks

Value Stocks

Sector Stocks

International Stocks

Country

Emerging Market Stocks

Long-term Bonds

Mid-term Bonds

Short-term Bonds

Real Estate Investment Trusts

Large-cap, or stocks with high market value (capitalization), includethe largest companies in a market. In the US, the Dow Jones Industrialsor the S&P 500 are the most famous indexes following these. Mid-cap,or middle capitalization stocks, are the next tier of company in termsof size, while small-cap brings up the rear with the smallest publicSmall stocks typically outperform over the long-term but are riskier.Some markets even have a micro-cap category.

Investors are essentially paying for the expectation of a stream of

future earnings, and the growth/value demarcation is a useful onealong lines of earnings. Growth stocks represent the half of a market'scompanies with higher-than-average stock price-to-earnings ratios (orsimilar valuation ratio). This suggests an expectation that they willgrow their earnings faster than average so that in coming years theprice paid for earnings will ultimately be low.


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Value stocks are just the opposite and have lower-than-average stockprice-to-earnings ratios. Normally investors expect these firms to growmore slowly and therefore pay less as a percentage of today'searnings. Investors are comforted by knowing value companies don'tneed to improve earnings to meet their expectations. Growth and

value can be applied to an entire market or a subset.

Sector stocks are groups of companies in the same industry. They arequite useful to play a hunch on a particular part of the economy.

International stocks are companies of non-US, usually developedeconomies. Europe, Asia, Australia are examples. They may spanregions or individual countries only. Emerging market stocks are stocksof developing countries and are generally quite risky but often sportlow price per earnings and substantial potential earnings growth. Braziland Russia are examples.

Long-term bonds provide a guaranteed rate of return for a period (ortime to maturity) of more than 7 years or so. They carry high interestrate risk, since the bonds lock in a rate for many years, a general risein interest rates will quickly depress the value of the bonds. And vice-versa, interest rate drops will increase the bonds' value, sinceinvestors will flock to them in search of interest rates higher than inthe open market. Medium-term bonds generally pay somewhat lessthan long-term and are less sensitive to interest rate movements.Usually medium-term refers to 3-5 years. Short-term bonds pay theleast but are essentially impervious to interest rates. Bond dividends

are considered ordinary income and taxable at relatively high rates.

Bonds may be backed by governments or corporations. US Treasuriesare considered risk-free but state or city bonds may have higher yieldsand corresponding risk. Investment-grade corporate bonds are ratedfor a modest level of risk by independent ratings agencies, and theypay somewhat higher dividends than treasuries. High-yield bonds, onthe other hand, are deemed risky and generally pay handsomedividends to reflect the outsize risk they present.

Real-estate investment trusts (REITs) are funds that invest in large

numbers of commercial properties. They tend not to move in tandemwith stocks and thus offer diversification to a portfolio. They maydeliver capital appreciation but mostly generate ordinary incomedividends.

There is even a gold ETF, backed by actual gold bullion stored in avault.


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These and other asset class categories may be used together to obtainfiner-grained asset classes. Thus small value stocks are an asset classin their own right, and ETFs are being created every month aroundthese subclasses. Only investable, publicly traded companies arerepresented, and private firms are excluded.

-------------------------------------------

References:

1. Credit for discovering this effect is normally given to Gary Brinsonfor his article"Determinants of Portfolio Performance", published inFinancial Analysts Journal in 1986. This study has been repeatednumerous times by other researchers ever since, with no significantdeviation in the fundamental conclusion

Using ETF Options Conservatively

Investors believe options are risky, and rightly so when they are usedalone. But they take on a new light when an investor already owns anasset being optioned. ETF investors in particular can exploit their useto protect their holdings in an entirely conservative manner.

Want to lock in profits from a recent run-up in an ETF without sellingthe position and triggering taxes? Want to buy insurance against adrop in a shaky market? These and other defensive strategies can beobtained with the nearly 70 ETF options currently available. Although

many large stocks offer options, trying to engage in many at oncebecomes a nightmare of expense, tracking and paperwork. EFTs makedefensive options easy.

Options are the right to buy (called a call) or to sell (called a put) astock at a certain price before a certain date. These rights have valueand are themselves bought and sold on stock exchanges at evolvingprices that reflect the fortunes of the underlying stock or ETF and thetime left in the contract.

A call is normally speculative because the option may expire worthless

for the buyer, or the option may shoot up dramatically and expose theseller to huge losses. But selling calls when the investor is "covered",or owns the underlying ETF, is inherently conservative. It can belikened to the farmer selling his wheat in July even though harvestdoes not occur until October. It is a time-honored and reasonablepractice. The seller is pocketing the option cash as a way to lock inprofit or to insure against mild loss. Selling uncovered calls, on theother hand, exposes the seller to nearly limitless risk since there is no


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way to know how high the underlying stocks could rise. The followingtable shows some outcomes for a typical covered call sold for $10 for astrike price of the underlying ETF at $110 in a year's time, whileassuming the ETF is currently trading at $100:

ETFattains:

Profit/Loss calculation Difference from no action

$130$10 gain (ETF called at $110) +$10 option income= $20

-$10 since no action wouldhave led to $30 ETF gain

$120$10 ETF gain (ETF called at$110) + $10 option income=$20

break even since no actionwould have led to $20 gain

$110$10 ETF gain + $10 optionincome=$20

+$10 since no action wouldhave led to $10 ETF gain

$100 No ETF gain + $10 optionincome=$10 +$10 since no action wouldhave led to no ETF gain

The difference between adopting this strategy and doing nothingdepends upon just how high the ETF will rise before the expirationdate. If fails to climb by more than the amount of the option income,then the strategy puts another $10 in the investor's pocket. That's anextra 10% return in the case of the ETF remaining flat or 10% cushionagainst decline. The covered call is well suited when the investor wantsan income stream and is neither bullish nor bearish about a market.

The downside of covered calls is that the prospect of steady incomecan lure an investor into ignoring signs of severe downturn. If theinvestor is truly bearish, covered calls will offer only limited protection.Inversely, covered calls remove most of any sharp rise that may occurfor the ETFs, so their owner gives up windfall profits, which made themunpopular in the boom years of the 1990s.

For deeper protection against loss, the options investor can purchaseputs for an ETF they hold. This gives them the opportunity to unloadthe ETF if it drops below the strike price in time. Bought alone, the putis speculative because there is a chance that it will expire worthless,

and sold alone exposes the investor to extensive loss since theunderlying stocks could drop sharply in value. Bought as an extensionto an existing position in an ETF, the put's role changes to one ofinsurance.

The following table shows outcomes for a typical protective put boughtfor $10 for a strike price of $90 a year away:


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ETF atExpiration


$100no ETF loss - $10 optioncost= -$10

-$10, cost of protective put

$90 $10 ETF loss -$10 optioncost= -$20

-$10 since ETF alone wouldhave lost $10

$80$10 ETF loss (ETF put at$90) - $10 = -$20

None, since ETF alone wouldhave lost $20


+$10, since ETF alone wouldhave lost $30

Puts make sense if the ETF owner is concerned about serious loss for ashort period of time. As with many investments, the price of an optionis critical. They are often too expensive to be considered for repeated

use. If an investor is truly bearish for the long-term, investors shouldconsider selling out completely. Puts are best used opportunistically.

As with all financial instruments, the price paid or received for anoption is critical. Sound strategies lose their appeal when they becometoo expensive to implement.

Transaction fees should be factored in, but in context they can be justified when the alternative of selling out an entire underlyingposition also generates fees. Tax considerations are also mixed. Whileincome derived from them generally does not enjoy low long-term tax

gain treatment, they can help investors avoid incurring capital gainsfrom selling the underlying position.

Options will remain another benefit of ETF ownership and an important,if occasional, tool when used in proper context.

Safe Options: Protecting Profits with ETFs

Investors believe options are risky, and rightly so when they are usedalone. But they take on a new light when an investor already owns anasset being optioned. ETF investors in particular can exploit their use

to protect their holdings in an entirely conservative manner.

Want to lock in profits from a recent run-up in an ETF without sellingthe position and triggering taxes? Want to buy insurance against adrop in a shaky market? These and other defensive strategies can beobtained with the nearly 70 ETF options currently available. Althoughmany large stocks offer options, trying to engage in many at once


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becomes a nightmare of expense, tracking and paperwork. ETFs makedefensive options easy.

Options are the right to buy (called a call) or to sell (called a put) astock at a certain price before a certain date. These rights have value

and are themselves bought and sold on stock exchanges at evolvingprices that reflect the fortunes of the underlying and the time left inthe contract.

A call is normally speculative because the option will expire worthlessfor the buyer, or the option may shoot up dramatically and expose theseller to huge losses. But selling calls when the investor is "covered",or owns the underlying ETF, is inherently conservative. It can belikened to the farmer selling his wheat in July even though harvestdoes not occur until October. It is a time-honored and reasonablepractice. The seller is pocketing the option cash as a way to lock in

profit or to insure against mild loss. Selling uncovered calls, on theother hand, exposes the seller to nearly limitless risk since there is noway to know how high the underlying stocks could rise. The followingtable shows some outcomes for a typical covered call sold for $10 for astrike price of the underlying ETF at $110 in a year's time, whileassuming the ETF is currently trading at $100:

ETFattains:


$130$10 gain (ETF called at $110) +

$10 option income= $20

-$10 since no action would

have led to $30 ETF gain

$120$10 ETF gain (ETF called at$110) + $10 option income=$20

break even since no actionwould have led to $20 gain

$110$10 ETF gain + $10 optionincome=$20

+$10 since no action wouldhave led to $10 ETF gain

$100No ETF gain + $10 optionincome=$10

+$10 since no action wouldhave led to no ETF gain

The difference between adopting this strategy and doing nothing

depends upon just how high the ETF will rise before the expirationdate. If it fails to climb by more than the amount of the option income,then the strategy puts another $10 in the investor's pocket. That's anextra 10% return in case the ETF remains flat or a 10% cushion againstdecline. The covered call is suitable when the investor wants anincome stream and is neither bullish nor bearish about a market.


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The downside of covered calls is that the prospect of steady incomecan lure an investor into ignoring signs of severe downturn. If theinvestor is truly bearish, covered calls will offer only limited protection.Inversely, covered calls remove most of any sharp rise that may occurfor the ETFs, so their owner gives up windfall profits. This made

covered calls unpopular in the boom years of the 1990s.

For deeper protection against loss, the options investor can purchaseputs for an ETF they hold. This gives them the opportunity to unloadthe ETF if it drops below the strike price in time. Bought alone, the putis speculative because there is a chance that it will expire worthless,and sold alone it exposes the investor to extensive loss since theunderlying stocks could drop sharply in value. Bought as an extensionto an existing position in an ETF, the put's role changes to one ofinsurance.

The following table shows outcomes for a typical protective put boughtfor $10 for a strike price of $90 a year away:

ETF atExpiration


$100no ETF loss - $10 optioncost= -$10

-$10, cost of protective put

$90$10 ETF loss -$10 optioncost= -$20

-$10 since ETF alone wouldhave lost $10


None, since ETF alone wouldhave lost $20


+$10, since ETF alone wouldhave lost $30

Buying puts makes sense if the ETF owner is concerned about seriousloss for a short period of time. As with many investments, the price ofan option is critical. They are often too expensive to be considered forrepeated use. If an investor is truly bearish for the long-term, investorsshould consider selling out completely. Puts are best usedopportunistically.

Transaction fees should be factored in, but in context they can be justified when the alternative of selling out an entire underlyingposition also generates fees. Tax considerations are also mixed. Whileincome derived from them generally does not enjoy low long-term taxgain treatment, they can help investors avoid incurring capital gainsfrom selling the underlying position.


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Options will remain another benefit of ETF ownership and an important,if occasional, tool when used in proper context.

ETFs vs. (Open-End) Mutual Funds

There are many advantages to ETFs, and these advantages will likelyincrease as ETFs are improved. Most ETFs have a lower MER(management expense ratio) than comparable mutual funds. Mutualfunds generally charge 1% to 3% while ETFs are almost always in the0.2% to 1% range. Over the long term, these cost differences cancompound into a noticeable difference.

ETFs are also more tax-efficient than mutual funds. Mutual funds cantrigger capital gains when large number of holders redeem theirshares. In contrast, ETFs are not redeemed by holders (instead, holderssimply sell their ETF on the stock market, as you would a stock).

Perhaps the most important, although subtle, benefit of an ETF is thestock-like features offered. Since ETFs trade on the market, you cancarry out trades similar to a stock. For instance, you can short, use astop-loss order, buy on margin, and invest as much money as you want(there is no minimum investment requirement). Mutual funds do notoffer those features. For example, you cannot place a stop loss order

on a mutual fund.

ETFs also have some disadvantages when compared with (open-end)mutual funds. One such disadvantage stems from the fact that manymutual funds are actively managed. Mutual fund managers can seekout undervalued and profitable firms whereas ETFs typically just trackan index. (Some studies have shown that 70% mutual fund managersdo not beat a passive index. However, professional mutual fundmanagers may be better for small-cap, foreign, and similar areas).

Source:

ETFZone staff

www.mutualfundsindia.com
http://www.mutualfundsindia.com/http://www.mutualfundsindia.com/


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Documents

Indian Institute of Planning & Management