Exchange Traded Fund -- a new asset category for investors

Exchange Traded Funds (ETF), first introduced in 1993, are offshoots of mutual funds that allow investors to trade in index portfolios just as shares of stock. ETF is a pooled investment vehicle with shares that trade on stock-exchanges at a market determined price. Investors may buy or sell ETF shares through a broker or in a brokerage account. It is like an open end mutual fund but it is traded in the secondary market and experience price changes throughout the day as they are bought and sold like shares.

Typically, ETFs are created to mimic a particular index. Purchasing an ETF essentially means you are purchasing an index. ETF is a passive investment vehicle which does not want to beat the market rather it goes hand in hand with the market.

When an Investment Bank, the ETF sponsor, wants to create new shares of its fund, whether to launch a new product or meet increasing market demand, it turns to someone called an Authorised Participant (AP). An AP may be a market maker, a specialist or a large financial institution. But essentially, an AP is supposed to have a lot of buying power. It is the AP's job to acquire the securities that the ETF wants to hold. For instance, if an ETF is designed to track the DS30 Index, the AP will buy shares of all the DS30 constituents in the exact same weights as the index, and then deliver those shares to the ETF provider. In exchange, the provider gives the AP a block of equally valued ETF shares, called a Creation Unit. These blocks are usually formed in blocks of 50,000 shares. The exchange takes place on a one-for-one, fair value basis. The AP delivers a certain amount of underlying securities and receives the exact same value in ETF shares, priced based on their net asset value (NAV), not the market value at which the ETF happens to be trading. Both parties benefit from the transaction; the ETF provider gets the stocks it needs to track the index, and the AP gets plenty of ETF shares to resell for profit. The process can also work in reverse. APs can remove ETF shares from the market by purchasing enough of those shares to form a creation unit and then delivering those shares to the ETF issuer. In exchange, APs receive the same value in the underlying securities of the fund. This is called the redemption of ETF.

One major difference between an ETF and stocks is that price of a stock may shoot up or down based on mismatch in demand and supply as the supply of stock is limited to the number of free float stocks. The beauty of ETF is that based on market demand, the supply of ETF can be increased or decreased. So, an ETF cannot trade above its fair value for a long time. If many investors want to buy an ETF, the ETF's share price might rise above the value of its underlying securities. When this happens, the AP can jump in to intervene. Recognising the overpriced ETF, the AP might buy up the underlying shares that compose the ETF and then sell ETF shares on the open market thus increasing supply of ETF shares. This should help drive the ETF's share price back towards fair value, while the AP earns a basically risk-free arbitrage profit. Likewise, if the ETF starts trading at a discount of the securities it holds, the AP can buy ETF shares from the market at a lower price thus reducing supply of ETF from the market and redeem them for the underlying securities, which can be resold. By buying up the undervalued ETF shares, the AP drives the price of the ETF back toward fair value while once again making a profit. This arbitrage process helps to keep an ETF's price in line with the value of its underlying portfolio.

Very soon, ETF is going to be launched in Bangladesh. Introduction of ETF means a new asset will be available to investors. ETF can be expected to bring more foreign participation in the capital market as it is a good choice for foreign fund managers to allocate their funds since they can reap the benefit of investing in a diversified portfolio by purchasing a single script and it is a passive strategy, so less costly as well. After its introduction, participation of large institutional investors are likely to increase which in turn will increase the volume of trade in the market and thus both the stock exchanges and the brokerage houses will pocket extra profit after the trading of ETF starts in the stock exchanges. APs can avail arbitrage opportunity through this investment vehicle.

ETF shares are expected to be less volatile than stocks and mutual funds. Stocks and closed end mutual funds have finite supply of shares. Due to unmatched demand supply condition, their market price can move up or down significantly. But this is not the case in case of ETF shares. It is safer and more liquid than stocks and mutual funds since APs have to assume their market maker role whenever there is a mismatch between demand and supply of ETF shares. We can hope that ETF will be a good way of low cost diversification for investors as it mimics stock index.

The capital market of Bangladesh is very small and not a well regulated one. Poor corporate governance and low quality financial disclosure is very common among the companies listed in the stock exchanges. Since the birth of Bangladesh, the stock market has experienced two major market crashes and so most people of the country are afraid of investing in capital market. The market is still inefficient and no extensive market reform programme is in the horizon. As a result, general people are more comfortable with low risk fixed return asset classes. When the perception of people is such, it is a matter of concern that introduction of ETF may not get the stimulus as expected.

The entire mutual fund industry in Bangladesh is in a shaky state with most of the mutual funds trading below their face value as well as their NAV. Most market participants do not understand how a mutual fund operates and those who understand lack trust in the managers of those funds. Also, mutual funds should have been a fixed income security which is expected to declare cash dividends each year, but in Bangladesh many mutual funds do not declare cash dividends, rather they issue Reinvestment Unit (RIU). Sometimes fund tenure is extended upon maturity and money is not returned to investors. As a result, there is less demand of mutual funds in the market and this is clearly evident from the mutual fund's trading significantly below the NAV.

Since ETF is a hybrid instrument with some of its features similar to those of mutual fund, launching a new instrument may face difficulties under the current circumstance. Lack of trust for the managers of mutual funds will become the major hindrance for the successful launching of ETFs. All the market participants related with ETF must be provided with extensive training regarding the pros and cons of ETF. In the long run, the success of ETFs will be tied with the economy in general and the capital market in particular as the underlying assets of the ETFs will be those stocks. If the listed companies do not perform well, the funds will not be able to create value for the investors.

Another important point to be noted here is that ETFs are mostly for large markets but not so lucrative in small markets. The institutional investors get more priority than small investors in ETF trading. Despite a few grey areas, the benefits from successfully launching a new asset category will have more positive impact in the market. If a congenial regulatory environment can be ensured, launching of this new investment vehicle is likely to be a success.

The writer is Assistant Manager, Corporate Business Development, BRAC EPL Stock Brokerage Limited. [email protected]