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UTI to launch exchange-traded fund

Aabhas Pandya

Unit Trust of India is planning to launch the first exchange-traded fund or ETF in the country. Christened Sensex UTI Notional Depository Receipts Scheme (SUNDER), the open-end fund will passively track the 30-scrip Sensex of the Bombay Stock Exchange. While ETFs are already a popular investment option in the US mutual fund industry and track a variety of indices, SUNDER will be the first exchange traded fund in the Indian fund industry and will be listed on the BSE.

What are exchange-traded funds?

As the name suggests, ETFs are a basket of securities that are traded, like individual stocks, on an exchange. Unlike regular open-end mutual funds, where one can enter or exit only at the end of the day, ETFs can be bought and sold throughout the trading day. Investors can also hedge their positions in the market by going long and short on ETFs. In a nutshell, anything you might do with a stock, you can do with an ETF.

On the other hand, even as these funds are traded on the bourses, the prices of these units (in this case, SUNDER) should ideally reflect the NAV throughout the trading day and thus, the premium and discount associated with close-end funds be theoretically avoided. However, in practice, asset management companies rely on an arbitrage mechanism and market makers (which will be explained later) to keep the trading prices roughly in line with the net asset values of their underlying portfolios. For SUNDER, UTI may also buyback units from the secondary market in order to enhance the NAV.

Another important feature of this product is that their shares cannot be bought from or sold back to the fund house like regular mutual funds since transactions take place in big block of units. Thus, in the case of SUNDER, an investor will have to buy a minimum of 250,000 units. No wonder, this means that only institutions and high net worth investors can afford to deal directly with the fund companies. The average investor will have to go through a broker to buy and sell shares.

Add to it, ETFs require in-kind transactions -- that is, you don't get cash when you redeem units, but get the underlying stocks. Thus, in the case of SUNDER, UTI will exchange the underlying stocks in the same weight as they have in the Sensex. If after any partial repurchase, the minimum units are less than 250,000, such holdings could be sold only through secondary market transaction.

However, the trust has kept the option to accept or pay cash in part or full while issuing or repurchasing units. Besides, for each issue and repurchase of units, UTI will charge a transaction fee of Rs 10,000. While the transaction fee may vary, it will not exceed Rs 25,000.

Arbitrage opportunities

As has been said above, ETFs do not necessarily trade at the net asset values of their underlying holdings. Instead, forces of supply and demand for the fund determine the market price. To a large extent, the supply and demand for the fund is driven by the underlying value of the portfolios, but other factors do affect market prices. As a result, there is every possibility that ETFs will trade at prices above or below the value of their underlying portfolios. However, what typically happens is that by permitting large investors to buy or redeem shares in-kind, the fund companies behind ETFs create a mechanism that should help prevent sustained discounts or premiums.

Thus, if an ETF traded at a discount to its net asset value, institutional investors could assemble unit blocks (say 250,000 in case of SUNDER) in the open market at the discounted price, redeem them for the underlying stocks, and sell those stocks at a profit. Clearly, the arbitrage opportunity would generate sufficient demand for the discounted fund to narrow the gap between the market price and the NAV of the underlying portfolio.

The cost factor

Since ETFs are passively managed, they have lower annual expenses that actively managed funds. However, this is just one part of the story. As the case with stocks, an investor buying ETF must pay brokerage to buy and sell in the secondary market. Thus, if you are a regular investor in the mutual fund industry, you may end up paying more than what you would with a regular mutual fund. Similarly, those investors, who trade frequently, would also find their cost inflated.

Relevance in India

While SUNDER is another passively managed index fund, it will be traded on BSE and available to investors in towns and cities with BSE terminals. Besides, as the fund is listed on other bourses, the geographical reach of the product will be further enhanced. Surely, this kind of a product can do wonders for a number of AMCs, which do not have the necessary distribution strength.

However, the idea to launch an ETF could have been made better had UTI decided on a lower lot against the current 250,000 units. This would have meant larger investor participation. Add to it, UTI should provide facility to buy fresh units online through a broker, which would lead to an expansion in the unit capital. In the current set-up, as in the case of a regular fund, investors will have to approach UTI for fresh investments. Thus, investors transacting online will not be purchasing fresh units but buying and selling from the existing unit capital.

Nonetheless, ETFs are signs of a maturing market and the concept should surely become popular, with the flexibility to buy and sell units online. Thus, funds are not required to be physically present in every nook and corner of the country. While SUNDER may not catch the imagination of investors since most funds today comprehensively beat the Sensex, the product is expected to catch on once we have funds tracking a narrow basket of stocks or fast paced indices like the technology index.

Source: Value Research

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