What is an ETF?

B. Venkatesh

UNIT Trust of India is planning to launch an exchange-traded fund(ETF) called the Sensex UTI Notional Depository Receipts.

What is an ETF? This is a structured product that combines the benefits of a mutual fund and of a share listed at the stock exchange. How?

An ETF is like a mutual fund in that one unit, comprises a basket of underlying shares. For instance, each unit of UTI's proposed ETF will comprise of the stocks constituting the Sensex. An ETF, thus, enjoys the benefits of diversification such as a unit in a mutual fund.

But unlike an open-ended fund, the ETF is listed in the stock exchange as any other share. You can, thus, buy UTI's proposed ETF units just as you buy Infosys and Wipro in the market. But what difference does it make whether you buy/sell the units in the market or with the mutual fund? Well, the difference is in the expense ratio and intra-day prices.

Take the expense ratio. Typically, unit-holders lose a certain proportion of the income generated by the fund as expenses. Such expenses could be high for an open-end fund that changes its portfolio to adjust to the constant cash inflows and redemptions. An ETF does not suffer from this factor as the units are traded only in the stock market.

You may be quick to point out that the close-end fund also enjoys such an advantage. True, but the problem with a close-end fund is that such units trade at a substantial discount to the net asset value. This has not, however, been the case with ETF, if evidence from the US is anything go by.

Another advantage is that an ETF can be sold anytime in the market at the prevailing price just as any stock. You can, thus, take advantage of large intra-day movements in prices of the shares underlying the ETF. This is not possible with an open-end fund as you can buy/sell the units only at the day's closing price. It is for these reasons that ETFs exist by the dozen in the US. Will ETFs become popular in India?