Mutual Funds
Market volatility exposes perils of Exchange Traded Funds

ETFs combine the advantages of index funds and stocks. But because they are bought through a bourse, they are exposed to the mercy of the market’s liquidity

Exchange-traded funds (ETFs) are becoming increasingly popular. And yet, investors may be buying ETFs without fully realising the downside of them-low liquidity that can play havoc with the price at which you buy and sell when the market is volatile.

ETFs are supposed to combine the advantages of both index funds and stocks. They are easy to use and can be traded in any quantity, just like stocks. ETFs provide diversification, market tracking, transparency of an index-based mutual fund and come at low costs. Prices for ETFs are determined continuously in exchange trading. Orders are executed immediately. ETFs can be traded at any time while the stock market is functioning. It is like investing in shares where you can theoretically buy and sell on a daily basis. That leads us to the flip side of ETFs.

One of the biggest negatives is precisely that you have to buy them through an exchange-and, therefore, you are at the mercy of the market's liquidity.

Low trading volumes in particular ETFs can lead to low liquidity. If a particular market is not as efficient as it should be, it will take time to match an ETF seller with a buyer. The bid-ask spread will be wide.

You could end up buying it at a premium and selling it at a discount.

Until an ETF becomes widely popular, this is common in thinly-traded markets.

And the more volatile the market, the wider is the bid-ask spread. Also remember, even the spread that does not look so wide in a normal market can widen dramatically in a volatile, especially a sharply falling, market. Let's look at some examples of thinly-traded ETFs.

The first Indian exchange traded fund-Nifty BeES from Benchmark Mutual Fund- tracks the S&P CNX Nifty Index, and is structured as an open-ended fund but unlike ordinary mutual funds, is listed on the NSE (National Stock Exchange) and trades like a stock. Each Nifty BeES unit is 1/10th of the S&P CNX Nifty Index value. Apart from NIFTY BeES, there is also Junior BeES (Nifty Junior Index) and Bank BeES (Bank Index), and yes, Liquid BeES (the world's first liquid ETF) and Gold BeES also.

But one of the most popular ETFs, Nifty BeES, is wide off the value of the Nifty index on which it is based. In the past two weeks, it has been off the Nifty by 2%-3% on an average.

Let's look at some more examples of thinly-traded ETFs.

The Hang Seng Benchmark Exchange Traded Scheme (Hang Seng BeES) is now traded on the NSE, brought to you by Benchmark Mutual Fund. If you try to buy it, you will find yourself to be a loner. There is hardly anybody buying and selling and so there is a huge gap between the bid-ask spreads. The impact cost will be high as indicated by the bid-ask spread of Rs36.28 (on an average). Similarly, Reliance Mutual Fund-Banking ETF (RELBANK), has a bid-ask spread of Rs20.08 (on an average). The average traded quantity for the past 10 days was just 113 units. UTI Mutual Fund's (UTI-Sunder) average traded quantity in the same period was just 82 units, with bid-ask spread of Rs135.65 (on an average).

Gold ETFs are very popular among fund companies. Every fund company is launching one. Beware of buying gold through ETFs. Many are thinly-traded. Religare Gold ETF's average bid-ask spread was Rs11.57 on the underlying value of 1gm of gold which was Rs2,429 at that time. For ICICI Prudential Mutual Fund's ICICI Prudential Gold ETF (IPGETF), the average traded quantity for the past 10 days was 626.7 units (average bid-ask spread was Rs23.54); for Axis Gold ETF (average traded quantity was 595 units for the past 10 days), the average bid-ask spread was Rs 29.8. Among the more liquid ETFs is Gold BeES from Benchmark Mutual Fund-Gold ETF.

As a result of the above scenario, if a buyer wants to buy some thousand units than he has to wait for a long time to get his buying price, or else he has to buy at a significantly high price. Conversely, if a seller wants to sell some thousand units than he has to wait for a long time to get his selling price while the market may fall further-or else he has to sell at a significantly low price.




6 years ago

Your (ML) Comment : "But one of the most popular ETFs, Nifty BeES, is wide off the value of the Nifty index on which it is based. In the past two weeks, it has been off the Nifty by 2%-3% on an average"

Comment : Nifty spot index is a price index & does not account for dividend.ETF is priced considering dividend received from underlying securities, e.g. in case of Nifty ETF invest in Nifty 50 companies. Many of these company gives dividend which is accounted in NAV of ETF. Because of this there is difference of NAV & Spot Nifty Index. So investors investing in Index ETFs are getting benefits of index movement & at same time benefits of dividend also."


6 years ago

your(ML) comment - "One of the biggest negatives is precisely that you have to buy them through an exchange-and, therefore, you are at the mercy of the market's liquidity"

Comment : "Investors are not at all at the mercy of market's liquidity. There is a concept of Authorized Participants, who manages & provides the liquidity at all the time. In normal share trading there is fix number of shares that are available in the market for trading (buying & selling). However as ETFs are mutual fund units, traded on exchange, any number of units can be created or redeemed on real time basis. Generally AMCs who are providing ETFs & market leader in ETF space, monitors the liquidity, bid-ask spared etc., on real time basis & manage the liquidity. So as an investors no one should worry about liquidity. "

Pradeep N

6 years ago

Are there no market makers for these?

I remember asking this to question to Ajit Dayal of Quantum, he said, please call us, we will ensure the liquidity is ensured via a Market maker.

Does the above works in India?

Growth during 12th Plan may be below 9%: Planning Commission

"We had projected 9.5% (growth) for the 12th Plan and then we scaled in down to 9%... But we will definitely move to 8.5%, 8.6% or 8.7%," minister of state for planning Ashwani Kumar informed newspersons

New Delhi: Amid worsening of the global financial problems, the Planning Commission today said it may settle for a modest growth target of 8.5% to 8.7% during the 12th Plan period as against 9% contemplated earlier, reports PTI.

"We had projected 9.5% (growth) for the 12th Plan and then we scaled in down to 9%... But today I don't feel it will be 9%... But we will definitely move to 8.5%, 8.6% or 8.7%," minister of state for planning Ashwani Kumar told reporters here.

He was replying to a query on the likely impact of the current financial meltdown due to the downgrade of the US' sovereign rating by Standard and Poor's (S&P) and slowdown in major economies and their effect on India's growth target.

Though the government is yet to finalise growth targets for the 12th Plan period, the Planning Commission was contemplating to raise the economic growth target to 9% during the five-year period, up from 8.2% likely in the current Plan.

The Planning Commission is slated to finalise the draft Approach Paper to the 12th Five Year (2012-2017) plan during the month and send it to Union Cabinet for vetting.

Asked about the government's preparedness to deal with the spill-over of the US rating downgrade into the economy, Mr Kumar said: "The situation is being watched. The finance ministry is in constant touch with the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) and they are prepared to deal with the situation as it emerges. There is no reason to panic."

Mr Kumar said that despite problems in the US and the Eurozone, India's economic fundamentals remain strong.

He cited three factors-high savings and investments ratio, demographic dividend with India having the world's largest population of youngsters and the massive $1 trillion infrastructure development programme during the 12th Plan-and said they will ensure that the country's growth rate remain strong.

"There may be a little pressure on exports but India's real growth story is driven by internal demand and consumption and this will compensate for any decline in exports," he said.

The minister added that the fall in commodity prices as a result of the US rating downgrade could help India's fiscal deficit target.

"A very important factor of the situation in the global economy is the sharp decline in the oil and commodity prices, which will ease the pressure of our import bill, thereby enabling us to reduce the country's fiscal deficit to about 4.6% this year," he said.

The reduction in fiscal deficit, from 4.7% in the last fiscal would help the government to leverage capacity for mopping up resources for various projects, Mr Kumar said.

He said yesterday's announcement by the government to allow Qualified Foreign Investors to invest in mutual funds' equity and debt schemes would facilitate in increasing investments from overseas.

The minister further said that foreign investors are expected to make a beeline for India considering the economic downturn in the US and Europe.

Mr Kumar added that the government has taken a number of steps-including awarding 56 road projects worth over Rs63,000 crore in last two years-as part of its financial reform programme.

He, however, said that frequent disruption of Parliament by opposition parties and lack of consensus among the parties has prevented it from fulfilling others.


Whom will the SME exchange benefit?

Given the poor interest of retail investors, state of the intermediaries and poor governance standards, SME exchanges are likely to be useless

While the market regulator has allowed the two national stock exchanges to launch exchanges for small and medium enterprises (SMEs) it is not clear whether these exchange segments have any chance of success. Given the current lack of interest among retail investors in equities, poor governance standards and absence of empathy for investors among regulators, SME exchanges are doomed to failure. SMEs are unlikely to look up to these exchanges to get access to funding, better valuation, and improvement in governance standards. Shady SMEs may in fact use the lax rules to exploit the system.

The rules of the new BSE SME specify that that the post-issue face value capital should not exceed Rs10 crore. The SMEs with post issue paid-up capital between Rs10 crore and Rs25 crore are given the option to list either on the SME Exchange or on the main board. The minimum application and trading lot size shall not be less than Rs1 lakh. The issues shall be 100% underwritten and merchant bankers shall underwrite 15% in their own account. SEBI (the Securities and Exchange Board of India) has compulsorily mandated market making of all scrips listed and traded on the SME Exchange. The market makers are required to provide two-way quotes for 75% of the time in a day.

These are designed for ease of entry, but in a country like India where the governance standards are so poor, this will cut both ways. Let's look at the possible pitfalls of the current set of rules based on ground realities. As per SEBI's rules, the merchant bankers shall be responsible for market-making for a minimum period of three years. We do not have the concept of seasoned market makers in the country as of now. Given the current state of investment banks, would they have the money, interest and desire to commit to market-making-that too of small companies?

As per the rule, the market maker shall be allowed to deregister by giving one-month notice to the exchange. What will happen to the illiquid SME and its investors? While the merchant banker is required to file a copy of the offer document (RHP, or red herring prospectus) with SEBI, the latter will not give any observation on it. Who will then monitor the quality of the SME issues, especially since SEBI even currently allows all kinds of shady companies to list, despite performing some oversight? The exchanges surely would not be interested in enforcing any governance standards. After all, the BSE is a den of illiquid and shell companies whose stocks are freely being manipulated, as Moneylife has repeatedly pointed out.

The compliance norms of SMEs have been simplified for no reason at all. They have been allowed to report results half-yearly, instead of quarterly. This is absolutely ridiculous. All companies now have to do e-filing of statutory accounting reports, income and sales tax etc. to the government.  Companies themselves are computerised in their accounting systems to obtain monthly reports. Basic financial accounting in all companies is directly on the computer. There is hence no technology limitation, on account of which the companies should submit half-yearly reports and not quarterly reports.

The lax rules also allow SMEs to send abridged versions of the annual reports instead of the full annual report. This will not help build investor confidence, especially in companies that are unknown. The SMEs have also been exempted from the criteria of track record of three years of profit making. It is sufficient to report profit in three out of five years for listing on the SME Exchange. This is another completely anti-investor rule. Why should small investors (no institutional investor would really be interested in small companies), be exposed to loss-making small companies, which anyway are far riskier? This will only encourage even more garbage to enter the listed space. Shares will be traded in a lot on the SME Exchange instead of single shares as is possible today. This is a deterrent for creating liquidity.

While formulating these harmful rules, the regulator seems to have forgotten that listing of small companies that happened in two large gushes in the mid-80s and mid-90s. The primary market scandal of 1994-95 led to the phenomenon of vanishing companies. Successive market scandals, price rigging, poor disclosures, and dubious accounting, etc., have meant poor returns and poor trading. Poor returns and illiquidity have put investors off the market, which in turn had discouraged businessmen to come and tap the public market for almost a decade. The NSE (National Stock Exchange) and BSE (Bombay Stock Exchange) had then put restrictions on small companies entering the market. The Indian market system, corporate governance standards and anti-investor bias has not changed much. The new small exchanges, if they ever get off the ground, will go the same way as the Over the Counter Exchange of India.


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