INDIAN INSTITUTE OF PLANNING &

MANAGEMENT
(ESTD 1973)
New Delhi

Financial Services
Project Report
On
Comparison of: ETF & INDEX FUND

Submitted To :- Prof. Amit Bagga

Submitted by:
Amit mittal
Gurupreet singh sahni
Priyanka kohli
Sheenam chugh
Tania chaandwani

Fall Winter 2004-06

FN2

ETFs & INDEX FUNDS

 CONTENTS COVERED

• Some exchange traded funds in India

• ETF in Indian context
• Index funds
• Advantages and Disadvantages
• ETF in international arena
• Difference b/w ETF and index fund
• Tracking error
• Which is beneficial for investing and how?

Some Exchange Traded Fund :

 • NIFTY BeES an Exchange Traded Fund launched by Benchmark
Mutual Fund in January 2002.
• Junior BeES an Exchange Traded Fund on CNX Nifty Junior,
launched by Benchmark Mutual Fund in February 2003.
• SUNDER an Exchange Traded Fund launched by UTI in July 2003.
• Liquid BeES an Exchange Traded Fund launched by Benchmark
Mutual Fund in July 2003.
• Bank BeES an Exchange Traded Fund (ETF) launched by
Benchmark Mutual Fund in May 2004.
• Benchmark Split Capital launched by Benchmark Mutual Fund on
August 2005

Introduction
What do VIPERS, SPIDERS, WEBS, DIAMONDS and CUBES have in
common? Well, they are all Exchange Traded Funds. VIPERS stands for
Vanguard Index Participation Receipts), SPDRs is Standard & Poors
Depository Receipts, pronounced "SPIDERS"), CUBES is the name given
for QQQ (called so because of its three 'Q's), and tracks the
technology-laden NASDAQ 100 stocks. Also, they are a new addition to
the vocabulary of the Indian investor in the domestic financial markets
and a new species in the kingdom of the innovative financial
instruments that have become buzzwords in the turbulent stock
markets. But ETFs are a novelty only in India. Exchange Traded Funds
have been in vogue in the global financial markets, especially the US
financial markets for a long time now and have $110 billion locked in
assets under management. An index of their popularity can be gauged
from the fact that about 60 per cent of the trading volumes on the
American Stock Exchange comes from ETFs.It is only now that these
funds are catching on in the domestic mutual fund market in Inida. UTI
has launched its own ETF called SUNDERS, after Becnhmark's BeES
and Prudential ICICI's SPIcE.

ETF: The History

Exchange Traded Funds came into existence in 1993 when, State

Street Global Advisors, together with the American Stock Exchange,
developed and launched the ETF market. The name of the product was
SPDRS. SPDR, which is benchmarked against the S&P 500 Index,
continues to be the most successful product with over $22 billion in
Assets Under Management. It currently enjoys tremendous liquidity,
averaging close to $1 billion in shares changing hands every day on
the American Stock Exchange. In fact, it consistently ranks as one of
the most active securities on the AMEX. In addition to launching the
SPDR, State Street Global Advisors and the AMEX also launched the
Dow Diamonds in 1998, benchmarked against the Dow Jones Industrial
Average. That year they also introduced the first sector ETFs, the
Select Sector SPDRs, benchmarked against the nine sectors making up
the S&P 500 Index. In 1999, they introduced the first ETF in Asia and
currently they are doing the same in other major markets around the
globe. Now subsequent to the roaring success of the ETF market, more
and more complex instruments revolving around the ETFs are coming
into being. Such an innovation are options and futures on ETFs. On
November 18, 2002, EUREX (European Exchange) launched Europe's
first futures and options on the most liquid ETFs.

ETF: the concept explained

An Exchange Traded Fund, as the name itself suggests; is a financial

instrument, tradable on a stock exchange, that invests in the stocks of
an index in approximately the same proportion as held in the index. An
ETF is a hybrid financial product, a cross between a stock and a mutual
fund. Like a stock it can be traded on a stock exchange, and like a
mutual fund it behaves like a diversified portfolio. In many ways it is an
index fund, with a few subtleties that put it in a separate league. Unlike
an open-ended index fund, where an investor purchases units from the
fund itself and to redeem them sells the units back to the fund and
thereby expanding or shrinking its corpus on each entry or exit from
the fund, in an ETF is listed on an exchange ensuring that the entry or
exit of investors has no effect on the fund corpus. An ETF is transacted
through a broker and held in dematerialized form. An ETF is different
from an Index Fund in another manner. Availability of real-time quotes
is another feature present in an ETF but absent in an Index Fund where
the previous days NAV is applied for buying or redeeming. This feature
makes the trading of the ETFs possible. Much like the units of a mutual
fund the ETF too, is divided into units called a "creation unit". The
name emanates probably from the process through which one comes
to acquire these units. The ETF units when purchased from the fund
house are purchased by surrendering the underlying stocks in of the
index the ETF tracks and thereby 'creating' the ETF unit.

In short, they are similar to index mutual funds, but are traded more
like a stock. As their name implies, Exchange Traded Funds (ETFs)
represent a basket of securities that are traded on an exchange. An
ETF is a hybrid financial product, a cross between a stock and a mutual
fund. Like a stock it can be traded on a stock exchange, and like a
mutual fund it behaves like a diversified portfolio. Unlike an open-
ended index fund, where an investor purchases units from the fund
itself and to redeem them sells the units back to the fund and thereby
expanding or shrinking its corpus on each entry or exit from the fund,
in an ETF is listed on an exchange ensuring that the entry or exit of
investors has no effect on the fund corpus. An ETF is a combination of
an open-end and a close-end fund. Like any open-end fund, you can
buy units with the fund. But there is a difference. In an open-end fund,
you will pay cash to buy units. In the case of an ETF, you are required
to provide the underlying shares to buy the units.

If the demand of the ETFs in the markets soars, the ETF would start
trading at a premium from its intrinsic value, which should be equal in
proportion to the index that it is charting. This premium would make
the buyers go to the fund house where they would have to redeem
their shares in the proportion held under each unit of the ETF. In case
of redemption in the market, the seller would get paid in cash and in
case the fund units are taken to the issuer, the seller would get paid in
kind that is the underlying shares that make up the index. ETF trading
also opens up the flood gates for some more complex trading
arrangements like arbitrage between the cash and futures market or
simply put - short selling. But there is a hitch as far as the Indian
capital markets is concerned: "shorting" is not allowed.

An ETF is basically created through an initial public offering (IPO) by

the Asset management companies in which only authorised
participants (Aps), institutions, large investors are allowed to
participate. These investors exchange their portfolio of stocks and a
cash component for ETFs also known as creation units. These
creation units are made of two components namely portfolio deposit
and cash component. Portfolio deposit consists of basket of shares
that make up an index and the cash component is the difference
between the applicable NAV and the market value of the portfolio
deposit, which arises mainly due to transaction costs, rounding of
shares and incidental expenses involved. These units can be either
held as investments or sold in the market to the retail investors. ETFs
can be also sold back to the mutual fund company but mutual funds
buy it at a heavy discount to encourage their selling on the exchanges.
The net asset value (NAV) of an ETF is the value of the underlying
components of the benchmark index held by the ETF, plus the accrued
dividends, less the accrued management fee.

How ETFs are traded

The trading of the ETF is based on a well-known mechanism called
arbitrage. But first, let us see how one can buy an ETF. There are two
ways in which one can buy an ETF. One is through the market and the
other is through the fund house that has issued the ETF. Now for the
pricing mechanism: if the demand of the ETFs in the markets soars, the
ETF would start trading at a premium from its intrinsic value, which
should be equal in proportion to the index that it is charting. This
premium would make the buyers go to the fund house where they
would have to redeem their shares in the proportion held under each
unit of the ETF. Such units that are bought directly from the fund house
are called "creation units". But usually the lot size in which one can
buy creation units is so high that only an authorized participant
(market maker) or institutional investors may have the wherewithal to
buy these. In such case the retail investor would have to go to the
market itself to buy the units of the ETF, the decision in turn depending
on the expectations of the future price movements of the ETF. In case
of redemption in the market, the seller would get paid in cash and in
case the fund units are taken to the issuer, the seller would get paid in
kind that is the underlying shares that make up the index. ETF trading
also opens up the flood gates for some more complex trading
arrangements like arbitrage between the cash and futures market or
simply put - short selling. But there is a hitch as far as the Indian
capital markets is concerned: "shorting" is not allowed. As a proxy, one
can borrow the units but that mechanism is not very efficient, as the
cost of borrowing happens to range between 12 to 18 per cent
depending on one's creditworthiness. Given below is a chart that
explains the trading mechanism.
Although ETFs are legally classified as open-end companies or Unit
Investment Trusts (UITs), they differ from traditional open-end
companies and UITs in the following respects:

• ETFs do not sell individual shares directly to investors and only

issue their shares in large blocks (blocks of 50,000 shares, for
example) that are known as "Creation Units."
• Investors generally do not purchase Creation Units with cash.
Instead, they buy Creation Units with a basket of securities that
generally mirrors the ETF’s portfolio. Those who purchase
Creation Units are frequently institutions.
• After purchasing a Creation Unit, an investor often splits it up
and sells the individual shares on a secondary market. This
permits other investors to purchase individual shares (instead of
Creation Units).
• Investors who want to sell their ETF shares have two options: (1)
they can sell individual shares to other investors on the
secondary market, or (2) they can sell the Creation Units back to
the ETF. In addition, ETFs generally redeem Creation Units by
giving investors the securities that comprise the portfolio instead
of cash. So, for example, an ETF invested in the stocks contained
in the Dow Jones Industrial Average (DJIA) would give a
redeeming shareholder the actual securities that constitute the
DJIA instead of cash. Because of the limited redeemability of ETF
shares, ETFs are not considered to be—and may not call
themselves—mutual funds.

An ETF, like any other type of investment company, will have a

prospectus. All investors that purchase Creation Units receive a
prospectus. Some ETFs also deliver a prospectus to secondary market
purchasers. ETFs that do not deliver a prospectus are required to give
investors a document known as a Product Description, which
summarizes key information about the ETF and explains how to obtain
a prospectus.

All ETFs will deliver a prospectus upon request. ETFs do not use
profiles. ETFs that are legally structured as open-end companies (but
not those that are structured as UITs) must also have statements of
additional information (SAIs). Open-end ETFs (but not UIT ETFs) must
provide shareholders with annual and semi-annual reports.

Advantages Of Exchange-Traded Funds

It was State Street Global Advisors who launched the first exchange-
traded fund (ETF) in 1993 with the introduction of the SPDR. Since
then, ETFs have continued to grow in popularity but also gather assets
at a rapid pace. The easiest way to understand ETFs is to think of them
as mutual funds that trade like stocks. Of course, trading like a stock is
just one of the many features that make ETFs so popular. Let's go over
these attractive features.

 Tradable and Diversifiable: The ultimate selling proposition of

an ETF lies in its twin feature of being tradable and diversifiable.
One can trade a stock but then it is not diversifiable. Or, one can
buy a mutual fund and thereby diversify but then the mutual
fund would not be tradable. Alternatively, one can diversify one's
risks by holding a portfolio of stocks and trade them but that
would be too much of a botheration for the lay investor. This
conflicts are reconciled by an ETF that is at once tradable and is
a diversified portfolio too. It is these two feature, working in
tandem, like the twin blades of a scissor that make it a financial
product of choice.
 Low cost: Just like an Index-Fund an Exchange Traded Fund
does not have to incur any costs on account of active fund
management because the fund is passively managed. As the
ETFs are listed on the exchange, the cost of distribution is low.
Furthermore, exchange traded mechanism reduces minimal
collection, disbursement and other processing charges.
 Transparency: Just like the index fund, the portfolio of an index
fund has no mystery to it. Everybody in the participating market
is aware of the stocks that it is tracking and therefore need not
worry about a change in the stocks being traded in.
 Makes multiple trading strategy possible: As has been said
earlier, ETFs have the utility of doubling up as arbitraging
instruments between the futures and cash markets. It also helps
in equitizing cash, i.e., changing cash into equities, at a low cost.
 A Bear market friend: In a volatile stock market, an ETF might
become an instrument of choice as it is not expected to be as
volatile and yet may be traded. This is borne out by the fact that
the assets of US ETFs have grown from $ 96 billion in January
2003 to $118 billion in May 2003.
 ETFs can be bought and sold throughout the trading day,
allowing for intraday trading - which is rare with mutual funds.
 Traders have the ability to short or buy ETFs on margin.
 Low annual expenses rival the cheapest mutual funds.
 Arbitrage between Futures and Cash market
 No separate form filling. A phone call to a broker or a click on the
net is needed.
 Ability to put limit orders
 Minimum investment is one unit
 The Benefits of Trading Like a Stock The easiest way to
highlight the advantage of the ETF trading like a stock is to
compare it to the trading of a mutual fund. Mutual funds are
priced once per day, at the close of business. Everyone
purchasing the fund that day gets the same price, regardless of
the time of day their purchase was made. Because, like
traditional stocks and bonds, ETFs can be traded intraday, they
provide an opportunity for investors to bet on the direction of
shorter-term market movements through the trading of a single
security. For example, if the S&P 500 is experiencing a steep rise
in price through the day, investors can try to take advantage of
this rise by purchasing an ETF that mirrors the index (such as a
SPDR), hold it for a few hours while the price continues to rise
and then sell it at a profit before the close of business. Investors
in a mutual fund that mirrors the S&P 500 do not have this
capability - by nature of the way it is traded, a mutual fund does
not allow investors to take advantage of the daily fluctuations of
its basket of securities.
The ETF's stock-like quality allows the investor to do more than
simply trade intraday. Unlike mutual funds, ETFs are also for
speculative trading strategies, such as short selling and trading
on margin. In short, the ETF allows investors to trade the entire
market as though it were one single stock.
 Low Expense Ratios Everybody loves to save money,
particularly investors who take their savings and put them to
work in their portfolios. In helping investors save money, ETFs
really shine. They offer all of the benefits associated with index
funds - such as low turnover and broad diversification (not to
mention the often-cited statistic that 80% of the more
expensive actively managed mutual funds fail to beat their
benchmarks) - plus ETFs cost a lot less. Compare the Vanguard
500 Index Fund, often cited as one of the lowest of the low-cost
index funds, and the SPDR 500 ETF. The Vanguard fund's
expense ratio of 18 basis points is significantly lower than the
100+ basis points often charged by actively managed mutual
funds. But when compared to the SPDR's 11-basis-point expense
ratio, the Vanguard fund's expense ratio looks quite high. In fact
the SPDR is 40% lower, which is tough to argue with.Do keep in
mind, however, that because ETFs trade through a brokerage
firm, each trade incurs a commission charge. To avoid letting
commission costs negate the value of the low expense ratio,
shop for a low-cost brokerage (trades under $10 are not
uncommon) and invest in increments of $1,000 or more.

 Diversification ETFs come in handy when investors want to

create a diversified portfolio. There are hundreds of ETFs
 available, and they cover every major index (those issued by
Dow Jones, S&P, Nasdaq) and sector of the equities market (large
caps, small caps, growth, value). There are international ETFs,
regional ETFs (Europe, Pacific Rim, emerging markets) and
country-specific (Japan, Australia, U.K.) ETFs. Specialized ETFs
cover specific industries (technology, biotech, energy) and
market niches (REITs, gold). And ETFs cover also other asset
classes, such as fixed income. While ETFs offer fewer choices in
the fixed-income arena, there are still plenty of options, including
ETFs composed of long-term bonds, mid-term bonds and short-
term bonds. While fixed-income ETFs are often selected for the
income produced by their dividends, some equity ETFs also pay
dividends. These payments can be deposited into a brokerage
account or reinvested. If you invest in a dividend-paying ETF, be
sure to check the fees prior to reinvesting the dividends, as some
firms offer free dividend reinvestment, while others do not.
Studies have shown that asset allocation is a primary factor
responsible for investment returns, and ETFs are a convenient
way for investors to build a portfolio that meets specific asset
allocation needs. For example, an investor seeking an allocation
of 80% stocks and 20% bonds can easily create that portfolio
with ETFs. That investor can even further diversify by dividing
the stock portion into large-cap growth and small-cap value
stocks, and the bond portion into mid-term and short-term
bonds. Or, it would be just as easy to create an 80/20 bond-to-
stock portfolio that includes ETFs tracking long-term bonds and
those tracking REITs. The large number of available ETFs enables
investors to quickly and easily build a diversified portfolio that
meets any asset allocation model.
 Tax Efficiency ETFs are a favorite among tax-aware investors
because the portfolios that ETFs represent are even more tax
efficient than index funds. In addition to offering low turnover - a
benefit associated with indexing - the unique structure of ETFs
enables investors trading large volumes (generally institutional
investors) to receive in-kind redemptions. This means that an
investor trading large volumes of ETFs can redeem them for the
shares of stocks that the ETFs track. This arrangement minimizes
tax implications for the investor exchanging the ETFs since the
investor can defer most taxes until the investment is sold.
Furthermore, you can choose ETFs that don't have large capital
gains distributions or pay dividends (because of the
particular kinds of stocks they track).

Summary The reasons for the popularity of ETFs are easy to

understand. The associated costs are low, and the portfolios are
flexible and tax efficient. This simple, convenient combination
 results in an investment that some people believe will one day
replace traditional mutual funds in most investor's portfolios.

Disadvantages of ETFs
Unfortunately, exchange traded funds do have some negatives:

 Absence of prior active market: In India ETFs being a new

instrument, there is no existing market that one could swim into
immediately after buying the product. So for the liquidity to be
reasonable, a large number of investors would have to buy into
the idea to make adequate liquidity possible.
 Large Investments: In order to deal directly with the fund
houses large capital investments are required. For example in
the case of Nifty BeES, a minimum creation unit size of 20000
units is required that would involve lakhs of rupees in
investment. This makes ETFs a market where the institutional
buyers and sellers become the big fish.
 Broker Charges: Broker charges have to be paid anyway when
trading in ETFs. This can be minimized by trading long but the
very charm of ETFs is destroyed because it is meant for being
traded more often than an index fund.
 Premiums and discounts: An ETF might trade at a discount to
the underlying shares. This means that although the shares
might be doing very well on the bourses, yet the ETF might be
traded at less than the market value of these stocks.
 Does not facilitate "rupee cost averaging": An ETF is not
appropriate for those investors who want to operate on the
strategy of "rupee cost averaging". This is because investors
investing some money into ETFs every month would have to
incur brokerage costs that are not to be incurred in case of
mutual fund units until and unless the scheme carries an entry
load.
 Unlike mutual funds, ETFs don't necessarily trade at the net
asset values of their underlying holdings, meaning an ETF could
potentially trade above or below the value of the underlying
portfolios.
 Slippage - as with stocks, there is a bid-ask spread, meaning you
might buy the ETF for 15 1/8 but can only sell it for 15 (which is
basically a hidden charge).

The Role of Arbitrage in ETFs

Critics of ETFs often cite the potential for ETFs to trade at a share price
that is not aligned with the value of the underlying securities. To help
us understand this concern, a simple representative example best tells
the story.

Assume an ETF is made up of only two underlying securities:

• Security A, which is worth $1 per share

• Security B, which is also worth $1 per share

In this example, most investors would expect one share of the ETF to
trade at $2.00 per share (the equivalent worth of Security A and
Security B). While this is a reasonable expectation, it is not always the
case. It is possible for the ETF to trade at $2.02 per share or $1.98 per
share or some other value.

If the ETF is trading at $2.02, investors buying shares of the ETF are
paying more for the shares than the underlying securities are worth.
This would seem to be a dangerous scenario for the average investor,
but in reality, it isn't a major problem because of arbitrage trading.

Here's how arbitrage sets the ETF back into equilibrium. The trading
price of an ETF is established at the close of business each day, just
like any other mutual fund.
ETF sponsors also announce the value of the underlying shares on a
daily basis. When the price of the ETF deviates from the value of the
underlying shares, the arbitragers spring into action. If the underlying
securities are trading at a lower price than the ETF shares, arbitragers
buy the underlying securities, redeem them for creation units, and
then sell the ETF shares on the open market for a profit. If underlying
securities are trading at higher values than the ETF shares, arbitragers
buy ETF shares on the open market, form creations units, redeem the
creation units in order to get the underlying securities, and then sell
the securities on the open market for a profit.
The actions of the arbitragers set the supply and demand of the ETFs
back into equilibrium to match the value of the underlying shares.

Because ETFs were used by institutional investors long before they

were discovered by the investing public, active arbitrage among
institutional investors has served to keep ETF shares trading at a range
that is close to the value of the underlying securities.

End Result
In a sense, ETFs have a lot in common with wrist watches. Everybody
wants their watch to tell the correct time, but they don't need to know
how the watch was built in order to benefit from it. With ETFs,
investors can enjoy the benefits associated with this unique and
attractive investment product, without even being aware of the
complicated series of events that make it work. But, of course, knowing
how those events work makes you a more educated investor, which is
the key to being a better investor.

Which Is Right for Investing?

Generally speaking, if you are a long-term investor making smaller,
periodic investments, you may want to consider traditional index
funds over ETFs, because index funds can be purchased with no
transaction commissions.
If you have longer time horizons and larger, lump-sum amounts, you
may want to consider ETFs over index funds if you are investing in a
taxable account.

ETFs tend to generate fewer capital gains than mutual funds due to the
low turnover of the securities that comprise them, and because they
are not required to sell securities to meet investor cash redemptions.
Keep in mind, however, that you will generate taxable capital
gains/losses if you sell the ETF shares.

Investment Applications
ETFs can be used as:

• Long term core holding - Due to its lower cost and ability to
insulate long-term holders from short-term traders makes it ideal
core holdings for small to large investors.
• Diversification for small amounts - One can buy even one
share of nifty ETFs lower for lower than Rs. 200 for getting
exposure in large cap 50 stocks in one go.
• Short term tactical play - ETFs are ideal for top down
investors to implement there near term views for either broader
equity markets or sectors.
• Equitising cash for new flows or restructuring the
portfolio - Many institutions before they invest in individual
stocks can use ETFs to get broad market exposure in order to a
underperformance.
• Arbitrage with futures - One can use ETFs to make profit out
of pricing anomalies of the future pricing if any.
• For writing covered index calls.
• Delta hedging for index options.
 • Longer-term short position (Difficult currently due very few
stock borrowers and lenders)
• Short term tactical play - ETFs are ideal for top down
investors to invest in short term.

Right now six ETFs are operating in the Indian mutual funds Industry.
Out of these Benchmark Mutual Fund manages four ETFs. Benchmark
was the first in India, which came up with an ETF called Nifty BeES in
January 2002. The other two are from Prudential ICICI Mutual Fund and
UTI Mutual Fund. The performance of the ETFs is mentioned below.

Performance as on July 29, 2005

Absolute Absolute
6 6
1 Benchmar
Scheme Name Month Month 1 Year
Year ks
s s
CNX
Bank BeES 32.06 87.01 17.99 85.45
Bankex
CNX Nifty
Junior BeES 17.93 60.77 17.10 59.61
Junior
Nifty BeES 13.76 42.20 S&P Nifty 15.14 42.85
S&P CNX NIFTY UTI
National Depository 15.12 43.95 S&P Nifty 15.14 42.85
Receipts Scheme
SENSEX Prudential ICICI
19.34 49.00 Sensex 18.95 49.12
Exchange Traded Fund

Another ETF doing the rounds is the Gold Exchange Traded Fund
(GETF), something that the Finance Minister P Chidambaram touched
in his budget speech this year. UTI Mutual Fund is believed to be toying
with the idea of launching a Gold fund, in which the investor will be
allowed to convert gold ornaments into tradable units and get returns
on it.

What Is an Index?
Index funds are mutual funds that attempt to copy the performance of
a stock market index. The most common index fund tries to track the
S&P 500 by purchasing all 500 stocks using the same percentages as
the index. Other indices that mutual funds try to copy include: Russell
2000, Wilshire 5000, MCSI-EAFE, Lehman-Brothers Aggregate Bond,
and NASDAQ 100.

Most indexes are a collection of securities that provide a statistical

measure of a market or a subset of a market. The earliest indexes
were designed to gauge the market's general direction. For example,
the Dow Jones® Industrial Average (DJIA®) was created in 1896 by
Charles Dow and originally tracked the performance of 12 large U.S.
stocks. The DJIA, like the S&P 500® and Wilshire 5000®, now serves as
a benchmark of how well all stocks on the American markets perform
each day.

How Indexes Work

Whether an index was created to gauge the performance of the
market, or as a benchmark to measure the performance of an
investment manager, most indexes are comprised of securities. Some
indexes use objective and transparent rules to determine their
constituent securities, while others are more subjective.
Reconstitution, or the periodic rebalancing of an index, is important
because security characteristics change over time.

For example, a small cap security can grow into a mid cap over time.
The timing of reconstitution is important, because it allows for close
mirroring of the market. Indexes need to be reconstituted regularly;
too frequent reconstitution, however, can result in turnover costs for
investors.

Over the long haul, it's pretty tough to beat the market, which
historically has churned out average annual returns of about 10%. In
the "If you can't beat 'em, join 'em" spirit, index funds were created.

Index mutual funds aim to match the performance of a securities index

by purchasing shares of all or nearly all of the stocks in that particular
index. The granddaddy of all index funds (and still the biggest index
fund), the Vanguard 500 Index, was created in 1976 for investors to
track the performance of the S&P 500, a broad index that lists 500
large companies from a cross-section of sectors. Since then, index
funds have cropped up that mirror just about every index out there:
small-cap indices, sector indices, you name it. Indeed, there are even
"enhanced" index funds that try to slightly exceed the performance of
a given benchmark, but that isn't always easy to do. (Another growing
segment of index funds are exchange-traded funds .)

Because the aim of most index funds is merely to mirror an index's

performance, the funds aren't actively managed. This means the
management fees are typically far less expensive than most mutual
funds. Their relatively low cost is a key factor in their popularity.

Keep in mind that index funds don't try to set the world on fire, they
only want to match an index. If the benchmark index goes up about
10% for the year, so does the index fund. If the benchmark declines
10% for the year, so does the index fund.

While the first index fund and other early index funds tried to match
indices such as the S&P 500 that represented a fairly broad swath of
the market, more recent index fund offerings, such as the Internet
index funds, are pretty concentrated, and shouldn't be construed as a
diversification strategy.

Like all investment vehicles, indexing has its proponents and its
detractors. Whether it works for you depends on what you want out of
your portfolio. Want to swing for the fences and take on some risk in a
bid to beat the pack? Try an actively managed fund. Want to "join
'em," and be content with matching the index of your choice? Look no
further.

Key Differences Between ETFs and Index Funds

ETFs Index Funds

Shares can be bought and sold at
intra-day market prices on an
exchange. If permitted by your
broker, shares on the secondary
market can be bought on margin
or by limit order, and may be sold
Shares can be bought and sold
directly from the fund at a net
asset value set once per day,
typically at 4 p.m. ET. Index funds
generally cannot be sold short or
bought on margin.
short subject to exchange rules.

Generally have lower expenses Tend to have lower expenses than

than traditional mutual funds traditional mutual funds.
(even index funds) and may have
some tax efficiencies at the fund
level.
When buying shares in the Investment minimums can vary by
secondary market, there are no fund, and fund shares can be
investment minimums (i.e., you either load or no-load.
can purchase a single share) or
sales charges other than the cost
of a stock transaction.
Rapid trading in the secondary Rapid trading by other investors
market by other investors does can create costs for other
not create costs for other shareholders since the fund
shareholders, and since the price manager must have cash on hand
is set throughout the day by the (or sell shares of securities to
market, there is no opportunity for generate cash) to satisfy
late trading. redemptions.
Shares are not individually Shares are individually
redeemable from the fund. redeemable from the fund.
Instead they must be sold on the
secondary market.
Shares are sold on the secondary Shares are redeemed at NAV.
market at market value, which
may be less than NAV. There are
no sales loads, however,
transactions on the secondary
market are subject to brokerage
commissions.

Following points distinguish ETFs from the index funds:

POINTS Exchange traded funds Index Funds

Intra-day YES NO
Trading
Tax Efficiency YES NO
Low expense YES NO
Ratio
Brokerage YES NO
Real Time YES End of the Day
Quotes
Tracking error LESS More
Liquidity Risk MORE NIL
Short Facility YES NO
Load Not applicable unless redeemed to Either Entry or Exit
mutual funds load

How ETFs work?

ETFs are securities certificates that state legal right of ownership over
part of a basket of individual stock certificates. Several different kinds
of financial firms are needed for ETFs to come into being, trade at
prices that closely match their underlying assets, and unwind when
investors no longer want them. Laying all the groundwork is the fund
manager. This is the main backer behind any ETF, and they must
submit a detailed plan for how the ETF will operate to be given
permission by the SEC to proceed.

In theory all that a fund manager needs to do is establish clear

procedures and describe precisely the composition of the ETF (which
changes infrequently) to the other firms involved in ETF creation and
redemption. In practice, however, only the very biggest institutional
money management firms with experience in indexing tend to play this
role, such as The Vanguard Group and Barclays Global Investors. They
direct pension funds with enormous baskets of stocks in markets all
over the world to loan stocks necessary for the creation process. They
also create demand by lining up customers, either institutional or
retail, to buy a newly introduced ETF.

The creation of an ETF officially begins with an authorized participant,

also referred to as a market maker or specialist. Highly scrutinized for
their integrity and operational competence, these middlemen
assemble the appropriate basket of stocks and send them to a
specially designated custodial bank for safekeeping. These baskets are
normally quite large, sufficient to purchase 10,000 to 50,000 shares of
the ETF in question. The custodial bank doublechecks that the basket
represents the requested ETF and forwards the ETF shares on to the
authorized participant. This is a so-called in-kind trade of essentially
equivalent items that does not trigger capital gains for investors.

The custodial bank holds the basket of stocks in the fund's account for
the fund manager to monitor. There isn't too much activity in these
accounts, but some cash comes into them for dividends and there are
a variety of oversight tasks to perform. Some managers have leeway
to use derivatives to track an index.

This flow of individual stocks and ETF certificates goes through the
Depository Trust Clearing Corp., the same US government agency that
records individual stock sales and keeps the official record of these
transactions. It records ETF transfer of title just like any stock. It
provides an extra layer of assurance against fraud.

Once the authorized participant obtains the ETF from the custodial
bank, it is free to sell it into the open market. From then on ETF shares
are sold and resold freely among investors on the open market.

Redemption is simply the reverse. An authorized participant buys a

large block of ETFs on the open market and sends it to the custodial
bank and in return receives back an equivalent basket of individual
stocks which are then sold on the open market or typically returned to
their loanees.

What motivates each player? The fund manager takes a small portion
of the fund's annual assets as their fee, clearly stated in the
prospectus available to all investors. The investors who loan stocks to
make up a basket make a small interest fee for the favor. The custodial
bank makes a small portion of assets likewise, usually paid for by the
fund manager out of management fees. The authorized participant is
primarily driven by profits from the difference in price between the
basket of stocks and the ETF and on part of the bid-ask spread of the
ETF itself. Whenever there is an opportunity to earn a little by buying
one and selling the other, the authorized participant will jump in.

The process might seem cumbersome but it does allow for

transparency and liquidity at modest cost. Everyone can see what goes
into an ETF, investor fees are clearly laid out, investors can be
confident that they can exit at any time, and even the authorized
participant's fees are guaranteed to be modest. If one allows ETF
prices to deviate from the underlying net asset value of the component
stocks, another can step in and take profit on the difference, so their
competition tends to keep ETF prices very close to it underlying Net
Asset Value (value of component stocks).

Why Exchange Traded Funds?

Exchange-Traded Funds, or ETFs, are index funds that trade just like
stocks on major stock exchanges. Want to invest in the market quickly
and cheaply? ETFs are the most practical vehicle. They help the
investor focus on what is most important, choice of asset classes.

All the major stock indexes including world stock exchanges have ETFs
based on them, including:

Dow Jones Industrial Average

Standard & Poor's 500 Index

Nasdaq Composite

There are ETFs for large US companies, small ones, real estate
investment trusts, international stocks, bonds, and even gold. Pick an
asset class that is publicly available and there is a good bet that it is
represented by an ETF or will be soon.

ETFs differ fundamentally from traditional mutual funds, which do not

trade midday. Traditional mutual funds take orders during Wall Street
trading hours, but the transactions actually occur at the close of the
market. The price they receive is the sum of the closing day prices of
all the stocks contained in the fund. Not so for ETFs, which trade
instantaneously all day long and allow an investor to lock in a price for
the underlying stocks immediately.

ETFs are economical to buy and especially to maintain over the long-
run, making them especially attractive for the typical buy-and-hold
investor. Annual fees are as low as .09% of assets, which is
breathtakingly low compared to the average mutual fund fees of 1.4%.
Although investors must pay a brokerage transaction to purchase
them, with discount brokers this becomes negligible with sizable
trades. There are a few easy-to-avoid pitfalls to watch out for. Tax
effects are also not to be ignored, and ETFs perform well after-tax.
They can be margined, and options based on them allow for various
defensive (or speculative) investing strategies.
Their safety as a securities instrument (considered separately from the
safety of any particular asset class they might represent) is considered
the same as stock certificates themselves. Internally, ETFs are far
more complex entities than mutual funds. A fascinating combination of
players, including brokers, money managers and market specialists
combine to make them run smoothly. Legally, ETFs are a class of
mutual fund as they fall under many of the same Securities Exchange
Commission rules that traditional mutual funds do. But their different
structure means that the SEC has imposed different requirements from
traditional mutual funds in how they are bought and sold.

ETFs are index funds at heart, so investors are encouraged to study

the philosophy of index investing which downplays stock picking in
favor of buying the market. But unlike most traditional index funds,
investors need not take a passive, buy-and-hold approach. ETFs are
also becoming favorites of hedge funds and day traders who like to pull
the trigger frequently. Both types of investors may coexist and in fact
strengthen each other by lowering overall transaction costs.

ETF Liquidity Myth Dispelled

We thought it was time to put a common misconception on exchange-

traded fund liquidity to rest.

Some investors appear to believe that the liquidity of an ETF is

dependent on the fund's average trading volume, or the number of
shares traded per day. However, this is not the case. Rather, a better
measure of ETF liquidity is the liquidity of the underlying stocks in the
index. Understanding this fact requires a brief look into how ETFs
function on a basic level.

Since ETFs trade like stocks, market makers (also called authorized
participants or APs) are the folks that order the creation and
redemption of ETF shares. Market makers build an ETF share from the
shares of the companies in the underlying index. They create or
redeem shares depending on the market demand for the ETF shares.

It should also be noted that market makers and specialists can create
and redeem shares to arbitrage premiums or discounts to the
underlying net asset value (NAV). This activity is beneficial to ETF
investors because it keeps the price of the fund in line with the NAV
and prevents specialists from making unfair markets. Think of it as a
mechanism that ensures retail investors like us will get a fair price as
the APs step all over each other trying to make a buck. Pretty neat,
huh?
Large brokerage houses such as Morgan Stanley and Salomon Smith
Barney also occasionally act as authorized participants when a client
makes a large order. Based on their ability to purchase the underlying
stocks in the ETF, they can create a huge number of ETF shares
instantly with little difficulty in a liquid index like the S&P 500. In
essence, there is enormous liquidity in ETFs based on popular indexes -
the AP just has to turn on the hose.

Not surprisingly, ETFs based on indexes that also have derivatives tied
to them have even slimmer bid-ask spreads. The reason is that there is
heightened interaction between the specialists, market makers, and
arbitrageurs. In other words, ETF shareholders benefit from this
increased competition because it narrows spreads. For example, State
Street Global Advisors recently reported that the average bid-ask
spread calculated over 160 days on SPDR 500 (AMEX:SPY - News) was
0.09%. More firms are researching ETF bid-ask spreads, and the results
confirm that ETFs tied to liquid indexes have very small spreads.

Investors with a healthy apocalypse complex might notice here that an

ETF's liquidity could dry up in severe market conditions. This did in fact
happen with a Malaysian basket of stocks after that country instituted
currency controls. We don't mean to harp on this fact, but investors
should at least be aware of this bit of ETF history.

However, if you have confidence in U.S. market liquidity then you

should feel safe using existing broad-based domestic ETFs, and their
history thus far bears that out. We would add that a wait-and-see
attitude could be beneficial for potential ETFs tied to illiquid indexes -
private securities or municipal bonds, for example.

To quantify ETF liquidity, Salomon Smith Barney has conducted several

"snapshot studies" that take random pictures of the ETF market to look
at bid-ask spreads of domestic and international ETFs. Below are the
results of the latest snapshot study conducted in January 2002, when
Salomon Smith Barney gathered data from 40 random snapshots taken
throughout the month.

Domestic ETFs
61,752
Average bid
shares
66,799
Average ask
shares
Average spread $0.18
Average spread % 0.330%
Cap-weighted avg.
$0.06
spread
Cap-weighted avg.
0.087%
spread %

Source: Salomon Smith Barney, Bloomberg, the AMEX

International ETFs
13,487
Average bid
shares
15,438
Average ask
shares
Average spread $0.19
Average spread % 0.867%
Cap-weighted avg.
$0.17
spread
Cap-weighted avg.
0.591%
spread %

Source: Salomon Smith Barney, Bloomberg, the AMEX

Salomon also looked at premiums and discounts for the domestic and
international ETFs. The tables below show that that the premiums and
discounts for ETFs are very small. Not surprisingly, the international
ETFs have larger premiums and discounts because the stocks are not
as accessible.

Domestic ETF Snapshot study -

Premiums/Discounts
Bid P/D Mid P/D Ask P/D
-
Average 0.0067% 0.1069%
0.0937%
Maximum 1.4550% 1.6430% 3.5760%
- - -
Minimum
1.2110% 0.7010% 0.5810%
- - -
Cap-weighted avg.
0.0006% 0.0028% 0.0050%

Source: Salomon Smith Barney, Bloomberg

International ETF Snapshot study -
Premiums/Discounts
Bid P/D Mid P/D Ask P/D
-
Average -0.0469% 0.3815%
0.4753%
Maximum 2.4603% 2.7778% 3.0952%
-
Minimum -3.3575% -2.9520%
3.8961%
-
Cap-weighted avg. -0.0110% 0.2846%
0.3066%

Source: Salomon Smith Barney, Bloomberg

The analysts who wrote the report noted that the results improve
dramatically each time they conduct the snapshot study. They also
said the growth in popularity of ETFs has helped shrink spreads,
although the growth in the number of smaller funds has probably had
an adverse affect on the overall results.

Additionally, a very competitive market was established in the

Vanguard Total Stock Market Vipers (AMEX:VTI - News). The managers
of other broad-based competitor ETFs have countered by shrinking
spreads in their own funds, according to Salomon Smith Barney.

Finally, the New York Stock Exchange is trading several AMEX-listed

ETFs, and the addition of more specialists has created increased
competition and helped reduce spreads even further.

Tax Advantages with ETFs

As luck would have it ETFs are also quite tax-efficient. Because of the
way they are created and redeemed, they allow an investor to pay
most of his capital gains upon final sale of the ETF, delaying it until the
very end. There is no way to avoid capital gains, but delaying it is
valuable because the amount that would have been paid to taxes can
continue to accumulate wealth. Exactly how much an investor benefits
after-tax depends on their marginal tax rate, the return of the
investment, and how long they hold the investment. Overall, ETFs are
similar to tax managed index mutual funds, slightly more efficient than
standard mutual funds, and significantly more efficient than actively
managed mutual funds.
Traditional mutual funds accumulate unrealized capital gains liabilities
for stocks that have risen in value. Upon sale of these stocks the fund
calculates and periodically distributes the capital gains to its investors
in proportion to their ownership. The following table illustrates a
comparison of ETFs versus standard index mutual funds:

Capital Gains Distributions as a Percentage of Assets, August 2000-

August 2001

Index Mutual
Index tracked ETF
Fund
0.05
S&P 500 0.00%
%
0.30
S&P MidCap 400 8.54%
%
0.17
Russell 2000 13.64%
%
0.24
S&P 500/Barra Value 6.53%
%
S&P SmallCap 600/Barra 0.44
7.13%
Value %
0.16
S&P 500/Barra Growth 0.00%
%
S&P SmallCap 600/Barra 0.81
5.24%
Growth %
0.31
Average 5.87%
%

(Source: Bloomberg, from May, 2002 issue of Financial Planning

Magazine)

Both types of funds in the table have modest distributions, certainly in

comparison to actively managed mutual funds. And the more turnover
from trying to pick stocks, the more an active fund will force investors
to pay the IRS. It's an ugly and little discussed fact that active mutual
fund investors can end up paying other investors' tax bills, especially in
a bear market. That's because investors who sell out before the day of
record for that distribution will not receive the tax bill, while loyal
investors who stay in will pay it for the entire amount!

How is it ETFs are so efficient? Through a regulatory loophole, ETFs are

considered to be created by trading equivalent certificates (the ETF for
the many stocks that make up the basket) in what is called an in-kind
trade. This exchange of essentially identical items does not trigger
capital gains, according to the IRS. Traditional mutual funds must go
into the open market and exchange cash for stocks and vice versa,
which trigger realization of gains. It's a subtle difference, admittedly,
but which results in an advantage for the ETF investor.

As always, there are exceptions. Occasionally an ETF fund that is only

a few years old may throw off unusually high distributions, in a market
downturn. But this is atypical.

Asset Allocation with ETFs

The importance of asset allocation, or deciding what percentage of a

portfolio to devote to various asset classes, cannot be overstated.
Investors spend enormous amounts of time and money picking
individual stocks, while they spend relatively little deciding what types
of stock or bond to their funds. It should be just the opposite.

Investors should spend most of their time on overall asset selection

and ignore individual stocks for the most part. Repeated studies(1) by
unbiased university researchers have shown that about 95% of money
managers' performance, for better or worse, can be explained by their
selection of asset classes, not by their selection of individual stocks.
When a stock performs well, invariably stocks from the same asset
classes follow in parallel. All one has to do is pick asset classes well to
outperform. Asset allocation is not necessarily easy, but it is less
detailed and time consuming than stock picking, and it rewards the
diligent investor handsomely.

Why is stock picking so unproductive? Most economists feel this is

because of the enormous competition in the markets. So many experts
are analyzing stocks that there is no public information others have not
examined and acted on. Insider information probably would give an
advantage but it is, of course, illegal to use for trading. The sheer cost
of sifting through information about individual companies raises the
hurdle further for stock picking funds to beat the market. One strategy
to avoid the crush of competition is to gravitate to lesser-known
companies, but this brings with it higher risk. The record clearly shows
that on average stock picking funds do not beat the market, and there
is no evidence that stock pickers who are initially successful can
maintain their edge over time.

Happily, ETFs are the ideal tool for the investor focused on asset
allocation. They represent just about every asset class available and
are cheap, liquid, and reliable. The primary asset classes in which ETFs
are available include:

Large Cap Stocks

Mid Cap Stocks

Small Cap Stocks

Growth Stocks

Value Stocks

Sector Stocks

International Stocks

Country

Emerging Market Stocks

Long-term Bonds

Mid-term Bonds

Short-term Bonds

Real Estate Investment Trusts

Large-cap, or stocks with high market value (capitalization), include

the largest companies in a market. In the US, the Dow Jones Industrials
or the S&P 500 are the most famous indexes following these. Mid-cap,
or middle capitalization stocks, are the next tier of company in terms
of size, while small-cap brings up the rear with the smallest public
Small stocks typically outperform over the long-term but are riskier.
Some markets even have a micro-cap category.

Investors are essentially paying for the expectation of a stream of

future earnings, and the growth/value demarcation is a useful one
along lines of earnings. Growth stocks represent the half of a market's
companies with higher-than-average stock price-to-earnings ratios (or
similar valuation ratio). This suggests an expectation that they will
grow their earnings faster than average so that in coming years the
price paid for earnings will ultimately be low.
Value stocks are just the opposite and have lower-than-average stock
price-to-earnings ratios. Normally investors expect these firms to grow
more slowly and therefore pay less as a percentage of today's
earnings. Investors are comforted by knowing value companies don't
need to improve earnings to meet their expectations. Growth and
value can be applied to an entire market or a subset.

Sector stocks are groups of companies in the same industry. They are
quite useful to play a hunch on a particular part of the economy.

International stocks are companies of non-US, usually developed

economies. Europe, Asia, Australia are examples. They may span
regions or individual countries only. Emerging market stocks are stocks
of developing countries and are generally quite risky but often sport
low price per earnings and substantial potential earnings growth. Brazil
and Russia are examples.

Long-term bonds provide a guaranteed rate of return for a period (or

time to maturity) of more than 7 years or so. They carry high interest
rate risk, since the bonds lock in a rate for many years, a general rise
in interest rates will quickly depress the value of the bonds. And vice-
versa, interest rate drops will increase the bonds' value, since
investors will flock to them in search of interest rates higher than in
the open market. Medium-term bonds generally pay somewhat less
than long-term and are less sensitive to interest rate movements.
Usually medium-term refers to 3-5 years. Short-term bonds pay the
least but are essentially impervious to interest rates. Bond dividends
are considered ordinary income and taxable at relatively high rates.

Bonds may be backed by governments or corporations. US Treasuries

are considered risk-free but state or city bonds may have higher yields
and corresponding risk. Investment-grade corporate bonds are rated
for a modest level of risk by independent ratings agencies, and they
pay somewhat higher dividends than treasuries. High-yield bonds, on
the other hand, are deemed risky and generally pay handsome
dividends to reflect the outsize risk they present.

Real-estate investment trusts (REITs) are funds that invest in large

numbers of commercial properties. They tend not to move in tandem
with stocks and thus offer diversification to a portfolio. They may
deliver capital appreciation but mostly generate ordinary income
dividends.

There is even a gold ETF, backed by actual gold bullion stored in a

vault.
These and other asset class categories may be used together to obtain
finer-grained asset classes. Thus small value stocks are an asset class
in their own right, and ETFs are being created every month around
these subclasses. Only investable, publicly traded companies are
represented, and private firms are excluded.

-------------------------------------------

References:

1. Credit for discovering this effect is normally given to Gary Brinson

for his article"Determinants of Portfolio Performance", published in
Financial Analysts Journal in 1986. This study has been repeated
numerous times by other researchers ever since, with no significant
deviation in the fundamental conclusion

Using ETF Options Conservatively

Investors believe options are risky, and rightly so when they are used
alone. But they take on a new light when an investor already owns an
asset being optioned. ETF investors in particular can exploit their use
to protect their holdings in an entirely conservative manner.

Want to lock in profits from a recent run-up in an ETF without selling

the position and triggering taxes? Want to buy insurance against a
drop in a shaky market? These and other defensive strategies can be
obtained with the nearly 70 ETF options currently available. Although
many large stocks offer options, trying to engage in many at once
becomes a nightmare of expense, tracking and paperwork. EFTs make
defensive options easy.

Options are the right to buy (called a call) or to sell (called a put) a
stock at a certain price before a certain date. These rights have value
and are themselves bought and sold on stock exchanges at evolving
prices that reflect the fortunes of the underlying stock or ETF and the
time left in the contract.

A call is normally speculative because the option may expire worthless

for the buyer, or the option may shoot up dramatically and expose the
seller to huge losses. But selling calls when the investor is "covered",
or owns the underlying ETF, is inherently conservative. It can be
likened to the farmer selling his wheat in July even though harvest
does not occur until October. It is a time-honored and reasonable
practice. The seller is pocketing the option cash as a way to lock in
profit or to insure against mild loss. Selling uncovered calls, on the
other hand, exposes the seller to nearly limitless risk since there is no
way to know how high the underlying stocks could rise. The following
table shows some outcomes for a typical covered call sold for $10 for a
strike price of the underlying ETF at $110 in a year's time, while
assuming the ETF is currently trading at $100:

ETF
Profit/Loss calculation Difference from no action
attains:
$10 gain (ETF called at $110) + -$10 since no action would
$130
$10 option income= $20 have led to $30 ETF gain
$10 ETF gain (ETF called at
break even since no action
$120 $110) + $10 option income=
would have led to $20 gain
$20
$10 ETF gain + $10 option +$10 since no action would
$110
income=$20 have led to $10 ETF gain
No ETF gain + $10 option +$10 since no action would
$100
income=$10 have led to no ETF gain

The difference between adopting this strategy and doing nothing

depends upon just how high the ETF will rise before the expiration
date. If fails to climb by more than the amount of the option income,
then the strategy puts another $10 in the investor's pocket. That's an
extra 10% return in the case of the ETF remaining flat or 10% cushion
against decline. The covered call is well suited when the investor wants
an income stream and is neither bullish nor bearish about a market.

The downside of covered calls is that the prospect of steady income

can lure an investor into ignoring signs of severe downturn. If the
investor is truly bearish, covered calls will offer only limited protection.
Inversely, covered calls remove most of any sharp rise that may occur
for the ETFs, so their owner gives up windfall profits, which made them
unpopular in the boom years of the 1990s.

For deeper protection against loss, the options investor can purchase
puts for an ETF they hold. This gives them the opportunity to unload
the ETF if it drops below the strike price in time. Bought alone, the put
is speculative because there is a chance that it will expire worthless,
and sold alone exposes the investor to extensive loss since the
underlying stocks could drop sharply in value. Bought as an extension
to an existing position in an ETF, the put's role changes to one of
insurance.

The following table shows outcomes for a typical protective put bought
for $10 for a strike price of $90 a year away:
ETF at
Profit/Loss calculation Difference from no action
Expiration
no ETF loss - $10 option
$100 -$10, cost of protective put
cost= -$10
$10 ETF loss -$10 option -$10 since ETF alone would
$90
cost= -$20 have lost $10
$10 ETF loss (ETF put at None, since ETF alone would
$80
$90) - $10 = -$20 have lost $20
$10 ETF loss (ETF put at +$10, since ETF alone would
$70
$90) - $10 = -$20 have lost $30

Puts make sense if the ETF owner is concerned about serious loss for a
short period of time. As with many investments, the price of an option
is critical. They are often too expensive to be considered for repeated
use. If an investor is truly bearish for the long-term, investors should
consider selling out completely. Puts are best used opportunistically.

As with all financial instruments, the price paid or received for an

option is critical. Sound strategies lose their appeal when they become
too expensive to implement.

Transaction fees should be factored in, but in context they can be

justified when the alternative of selling out an entire underlying
position also generates fees. Tax considerations are also mixed. While
income derived from them generally does not enjoy low long-term tax
gain treatment, they can help investors avoid incurring capital gains
from selling the underlying position.

Options will remain another benefit of ETF ownership and an important,

if occasional, tool when used in proper context.

Safe Options: Protecting Profits with ETFs

Investors believe options are risky, and rightly so when they are used
alone. But they take on a new light when an investor already owns an
asset being optioned. ETF investors in particular can exploit their use
to protect their holdings in an entirely conservative manner.

Want to lock in profits from a recent run-up in an ETF without selling

the position and triggering taxes? Want to buy insurance against a
drop in a shaky market? These and other defensive strategies can be
obtained with the nearly 70 ETF options currently available. Although
many large stocks offer options, trying to engage in many at once
becomes a nightmare of expense, tracking and paperwork. ETFs make
defensive options easy.

Options are the right to buy (called a call) or to sell (called a put) a
stock at a certain price before a certain date. These rights have value
and are themselves bought and sold on stock exchanges at evolving
prices that reflect the fortunes of the underlying and the time left in
the contract.

A call is normally speculative because the option will expire worthless

for the buyer, or the option may shoot up dramatically and expose the
seller to huge losses. But selling calls when the investor is "covered",
or owns the underlying ETF, is inherently conservative. It can be
likened to the farmer selling his wheat in July even though harvest
does not occur until October. It is a time-honored and reasonable
practice. The seller is pocketing the option cash as a way to lock in
profit or to insure against mild loss. Selling uncovered calls, on the
other hand, exposes the seller to nearly limitless risk since there is no
way to know how high the underlying stocks could rise. The following
table shows some outcomes for a typical covered call sold for $10 for a
strike price of the underlying ETF at $110 in a year's time, while
assuming the ETF is currently trading at $100:

ETF
Profit/Loss calculation Difference from no action
attains:
$10 gain (ETF called at $110) + -$10 since no action would
$130
$10 option income= $20 have led to $30 ETF gain
$10 ETF gain (ETF called at
break even since no action
$120 $110) + $10 option income=
would have led to $20 gain
$20
$10 ETF gain + $10 option +$10 since no action would
$110
income=$20 have led to $10 ETF gain
No ETF gain + $10 option +$10 since no action would
$100
income=$10 have led to no ETF gain

The difference between adopting this strategy and doing nothing

depends upon just how high the ETF will rise before the expiration
date. If it fails to climb by more than the amount of the option income,
then the strategy puts another $10 in the investor's pocket. That's an
extra 10% return in case the ETF remains flat or a 10% cushion against
decline. The covered call is suitable when the investor wants an
income stream and is neither bullish nor bearish about a market.
The downside of covered calls is that the prospect of steady income
can lure an investor into ignoring signs of severe downturn. If the
investor is truly bearish, covered calls will offer only limited protection.
Inversely, covered calls remove most of any sharp rise that may occur
for the ETFs, so their owner gives up windfall profits. This made
covered calls unpopular in the boom years of the 1990s.

For deeper protection against loss, the options investor can purchase
puts for an ETF they hold. This gives them the opportunity to unload
the ETF if it drops below the strike price in time. Bought alone, the put
is speculative because there is a chance that it will expire worthless,
and sold alone it exposes the investor to extensive loss since the
underlying stocks could drop sharply in value. Bought as an extension
to an existing position in an ETF, the put's role changes to one of
insurance.

The following table shows outcomes for a typical protective put bought
for $10 for a strike price of $90 a year away:

ETF at
Profit/Loss calculation Difference from no action
Expiration
no ETF loss - $10 option
$100 -$10, cost of protective put
cost= -$10
$10 ETF loss -$10 option -$10 since ETF alone would
$90
cost= -$20 have lost $10
$10 ETF loss (ETF put at None, since ETF alone would
$80
$90) - $10 = -$20 have lost $20
$10 ETF loss (ETF put at +$10, since ETF alone would
$70
$90) - $10 = -$20 have lost $30

Buying puts makes sense if the ETF owner is concerned about serious
loss for a short period of time. As with many investments, the price of
an option is critical. They are often too expensive to be considered for
repeated use. If an investor is truly bearish for the long-term, investors
should consider selling out completely. Puts are best used
opportunistically.

Transaction fees should be factored in, but in context they can be

justified when the alternative of selling out an entire underlying
position also generates fees. Tax considerations are also mixed. While
income derived from them generally does not enjoy low long-term tax
gain treatment, they can help investors avoid incurring capital gains
from selling the underlying position.
Options will remain another benefit of ETF ownership and an important,
if occasional, tool when used in proper context.

ETFs vs. (Open-End) Mutual Funds

There are many advantages to ETFs, and these advantages will likely
increase as ETFs are improved. Most ETFs have a lower MER
(management expense ratio) than comparable mutual funds. Mutual
funds generally charge 1% to 3% while ETFs are almost always in the
0.2% to 1% range. Over the long term, these cost differences can
compound into a noticeable difference.

ETFs are also more tax-efficient than mutual funds. Mutual funds can
trigger capital gains when large number of holders redeem their
shares. In contrast, ETFs are not redeemed by holders (instead, holders
simply sell their ETF on the stock market, as you would a stock).

Perhaps the most important, although subtle, benefit of an ETF is the

stock-like features offered. Since ETFs trade on the market, you can
carry out trades similar to a stock. For instance, you can short, use a
stop-loss order, buy on margin, and invest as much money as you want
(there is no minimum investment requirement). Mutual funds do not
offer those features. For example, you cannot place a stop loss order
on a mutual fund.

ETFs also have some disadvantages when compared with (open-end)

mutual funds. One such disadvantage stems from the fact that many
mutual funds are actively managed. Mutual fund managers can seek
out undervalued and profitable firms whereas ETFs typically just track
an index. (Some studies have shown that 70% mutual fund managers
do not beat a passive index. However, professional mutual fund
managers may be better for small-cap, foreign, and similar areas).

Source:

• ETFZone staff
• www.mutualfundsindia.com
• www.yahoo.finance.com
• www.amfiindia.com