Indian Financial

System
Cia-2

Piyush N
0911354
 4 bbm ‘D’
INTRODUCTION

An exchange-traded fund that is based on a basket of securities listed on various exchanges in

India. India ETFs aim to capture the major sectors of the Indian economy by owning a
diversified mix of major companies that represent the majority of the total market capitalization
of the Indian economy.

An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like
stocks. An ETF holds assets such as stocks, commodities, or bonds and trades at approximately
the same price as the net asset value of its underlying assets over the course of the trading day.

Most ETFs track an index, such as the S&P 500 or MSCI EAFE. ETFs may be attractive as
investments because of their low costs, tax efficiency, and stock-like features ETFs are the most
popular type of exchange-traded product.

Only so-called authorized participants (typically, large institutional investors) actually buy or sell
shares of an ETF directly from or to the fund manager, and then only in creation units, large
blocks of tens of thousands of ETF shares, which are usually exchanged in-kind with baskets of
the underlying securities.

Authorized participants may wish to invest in the ETF shares for the long-term, but usually act as
market makers on the open market, using their ability to exchange creation units with their
underlying securities to provide liquidity of the ETF shares and help ensure that their intraday
market price approximates to the net asset value of the underlying assets.4

Other investors, such as individuals using a retail broker, trade ETF shares on this secondary
market.

An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be
bought or sold at the end of each trading day for its net asset value, with the tradability feature of
a closed-end fund, which trades throughout the trading day at prices that may be more or less
than its net asset value.

Closed-end funds are not considered to be "ETFs", even though they are funds and are traded on
an exchange.

ETFs have been available in the US since 1993 and in Europe since 1999. In 1993, the first
country specific ETFs were a collaboration between MSCI, BGI and a small independent third
party Distribution firm called Funds Distributor, Inc. The product eventually evolved into the
iShares brand widely known around the globe.
ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange
Commission began to authorize the creation of actively managed ETFs.

ETF in INDIA

India has become a burgeoning economy with specific proficiency in knowledge-based sectors
such as information technology, financials and healthcare. India ETFs carry a higher expense
ratio than most domestic funds, but it should be noted that administrative costs will typically be
higher when international investments are involved due to increased exchange costs and
brokerage fees for trading on an international exchange.

A total of over $6 bn has flown into India [ Images ] through ETFs, making this equivalent to the
largest country funds.

One of the major trends in the asset management industry currently is the relentless rise of
exchange-traded funds. ETFs now account for over a trillion dollars in assets, up from only about
$75 billion in the year 2000. ETFs have gained huge popularity over the last decade as they can
be used to gain exposure to a number of asset classes including equity, fixed income,
commodities and currencies.

They can also be used to gain exposure on either side of a trade, i.e. long or short as well as on a
leveraged basis. ETFs have several advantages over index funds: In the types of asset classes
covered and ability to short as well as their ability to offer intra-day liquidity, being traded on the
secondary markets.

ETFs have now started becoming very popular in India as well, with over 25 per cent of all
secondary market FII flows into India coming through this route in 2009.

Despite this accelerated flow through ETFs into India, single-country India ETFs are still
extremely small compared to China or Brazil

The difference in size is really because of the much later launch of these products for India due to
historic regulatory issues. The cumulative flow into India from ETFs [both single-country and
Emerging Market (EM)] is over $6 billion (source: Credit Suisse) till date, making it equivalent
in absolute size to the largest country funds.

The reality today is that anyone trying to raise new money for either an India hedge fund or even
a long only mutual fund, is faced with intense competition from the ETF. The sad truth is that
over the last three years, very few funds have been able to outpace the benchmarks by enough of
a margin to justify their fees.

Most funds have also clustered around quite similar performance numbers, making
differentiation for investors difficult. Many investors were also spooked by the illiquidity of non-
index based stocks in India, when they tried to exit, and experienced significant price damage as
their funds liquidated holdings to meet redemptions.

Reason for the popularity of the ETFs, is the serious bruising most macro funds received in their
attempt to exit India in 2008, when markets got crushed. Macro funds are by definition not stock-
pickers, and are perfectly happy to play the index, rather than trying to get involved directly in
specific stocks.

For as they discovered, with the exception of a handful of index heavyweights, liquidity just
vanishes for most equities in India when markets retreat. Macro funds are very active and on the
margin, driving the global move away from dollar-based assets. ETFs are the perfect vehicle for
a top down macro fund to execute its strategy seamlessly.

Role of ETF in Capital Market

ETFs are radically changing the markets, to the point where they, and not the trading of the
underlying securities, are effectively setting the prices of stocks of smaller capitalization
companies, or the potential new growth companies of the future. In the process, ETFs that once
were an important low-cost way for investors to assemble diversified stock holdings are now
undermining the traditional price discovery role of exchanges and, in turn, discouraging new
companies from wanting to be listed on US exchanges.

That is not all. The proliferation of ETFs also poses unquantifiable but very real systemic risks of
the kind that were manifested very briefly during the ‘Flash Crash’ of May 6, 2010. Absent the
ETF-related reforms we outline below in this summary, and in more detail in the text, we believe
that other flash crashes of small capitalization company “melt ups,” potentially much mroe
severe than the one on May 6, are a virtual certainty.

Features

ETFs generally provide the easy diversification, low expense ratios, and tax efficiency of index
funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling,
and options. Because ETFs can be economically acquired, held, and disposed of, some investors
invest in ETF shares as a long-term investment for asset allocation purposes, while other
investors trade ETF shares frequently to implement market timing investment strategies.[5]
Among the advantages of ETFs are the following:[8][17]

* Lower costs - ETFs generally have lower costs than other investment products because most
ETFs are not actively managed and because ETFs are insulated from the costs of having to buy
and sell securities to accommodate shareholder purchases and redemptions. ETFs typically have
lower marketing, distribution and accounting expenses, and most ETFs do not have 12b-1 fees.

* Buying and selling flexibility - ETFs can be bought and sold at current market prices at any
time during the trading day, unlike mutual funds and unit investment trusts, which can only be
traded at the end of the trading day. As publicly traded securities, their shares can be purchased
on margin and sold short, enabling the use of hedging strategies, and traded using stop orders and
limit orders, which allow investors to specify the price points at which they are willing to trade.

* Tax efficiency - ETFs generally generate relatively low capital gains, because they typically
have low turnover of their portfolio securities. While this is an advantage they share with other
index funds, their tax efficiency is further enhanced because they do not have to sell securities to
meet investor redemptions.

* Market exposure and diversification - ETFs provide an economical way to rebalance

portfolio allocations and to "equitize" cash by investing it quickly. An index ETF inherently
provides diversification across an entire index. ETFs offer exposure to a diverse variety of
markets, including broad-based indexes, broad-based international and country-specific indexes,
industry sector-specific indexes, bond indexes, and commodities.

* Transparency - ETFs, whether index funds or actively managed, have transparent portfolios
and are priced at frequent intervals throughout the trading day.

Where Are ETF,s Used?

Exchange-traded funds (ETFs) are an investing innovation that combines the best features of
index mutual funds with the trading flexibility of individual securities. ETFs offer diversification,
low expense ratios and tax efficiency in a flexible investment that can be adapted to suit a
multitude of objectives. To reap the true benefit of investing in ETFs you need to use them
strategically. (To learn more about the features and benefits that ETFs offer, see Advantages of
Exchange-Traded Funds.)
At the most basic level, ETFs can be used as part of both long-term and short-term investment
strategies. Low expense ratios and high trading flexibility make them attractive alternatives to
traditional mutual funds.

Index Investing

From a strategic standpoint, the first and most obvious use of ETFs is as a tool to invest in broad-
market indexes. On the equity side, there are ETFs that mirror the S&P 500, the Nasdaq 100, the
Dow Jones Industrial Average (DJIA) and just about every other major market index. On the
fixed-income front, there are ETFs that track a variety of long-term and short-term bond indexes
including the Lehman 1-3 Year Treasury, the Lehman 20-Year Treasury and the Lehman
Aggregate Bond Index. (For more information on ETFs, read Five Ways To Find A Winning
ETF.)

Using ETFs to cover the major market sectors, you can quickly and easily assemble a low-cost,
broadly diversified index portfolio. With just two or three ETFs, you can create a portfolio that
covers nearly the entire equity market and a large portion of the fixed-income market. Once the
trades are complete, you can simply stick to a buy-and-hold strategy as you would with any other
index product, and your portfolio will move in tandem with its benchmark.

Actively Managing a Longer-Term Portfolio

In a similar fashion, you can create a broadly diversified portfolio but choose a more active-
management strategy instead of simply buying and holding to track the major indexes (which is
passive management). While the ETFs themselves are index funds (meaning there is no active
management on the part of the money manager overseeing the portfolio), this doesn't stop
investors from actively managing their holdings. For example, say you believe that short-term
bonds are set for a meteoric rise; you could sell your position(s) in the broader bond market and
instead buy an ETF that specializes in short-term issues - you could also do the same for your
expectations for equities.

Of course, the major market indexes represent only a portion of the many investment
opportunities that ETFs provide. If your core portfolio is already in place, you can augment your
core holdings with more specialized ETFs, which provide entry into a wide array of small-cap,
sector, commodity, international, emerging-market and other investing opportunities. There are
ETFs that track indexes in just about every area, including biotechnology, healthcare, REITs,
gold, Japan, Spain and more. By adding small positions in these niche holdings to your asset
allocation, you add a more aggressive supplement to your portfolio. Once again, you can buy and
hold to create a long-term portfolio, but you can use more active trading techniques too. For
example, if you think REITs are poised to take a tumble and gold is set to rise, trade out of your
REIT position and into gold in a matter of moments at any time during the trading day. (For
more information about the many varieties of ETFs, read Introduction to Exchange-Traded
Funds.)

Active Trading

If actively managing a long-term portfolio isn't spicy enough for your tastes, ETFs may still be
the right flavor for your palette. While long-term investors might eschew active- and day-trading
strategies, ETFs are the perfect vehicle if you are looking for a way to move frequently into and
out of an entire market or a particular market niche. Since ETFs trade intraday, like stocks or
bonds, they can be bought and sold rapidly in response to market movements, and unlike many
mutual funds, ETFs impose no penalties when you sell them without holding them for a set
period of time.

While it is true that you must pay a commission each time you trade ETFs, if you are aware of
this cost and the dollar value of your trade is high enough, the commission cost is nominal.

Also, since they trade intraday, ETFs can be bought long or sold short, used in hedge strategies
and bought on margin. If you can think of a strategy that can be implemented with a stock or
bond, that strategy can be applied with an ETF - but instead of trading the stock or bond issued
by a single company, you are trading an entire market or market segment.

Wrap Investing

For investors who prefer fee-based investments as opposed to commission-based trading, ETFs
are also part of various wrap programs. While ETF wrap products are still in their infancy, it's a
safe bet that more are coming soon.