Chapter- 1

INTRODUCTION
1.1 OVERVIEW

Talking about financial innovations, Exchange Traded Funds are specifically

considered as one of the most spectacular and innovative investment product created
so far but before understanding what ETFs are one needs to understand its
predecessor i.e. mutual funds. Mutual funds were created with the objective of
encouraging saving and investment and participation in the income, profits and gain
accruing to the corporation from the acquisition, holding, management and disposal of
securities. It is an investment vehicle that pools the money from various interested
investors and invests it in stocks, bonds etc. in line with the objective of the
investment scheme. The gains or income so generated is then distributed among the
investors proportionately after deducting the expenses and various levies. Thus mutual
funds provide a benefit of diversification to investor which ensures that funds’ share
value is not devastated if an individual company underperforms. This entire process is
looked after by a professional fund manager who is well trained and has the time and
resources to make the best informed investments decision.

When one considers of investing, returns are as good as the portfolio is constructed
and to get the portfolio right one has to get its asset allocation aligned with the
investment objectives. Once the target asset allocation is determined one needs to
identify the investment within each asset. There are several macro and micro factors
that effects market leading to variations in performance and staying update to such
factors constantly is not easy. In such cases a passive investment instrument like
Exchange Traded Funds can be an ideal solution.

With recent underperformance of most of the actively managed mutual funds in 2018
the focus of investors has been shifted towards passive investing and especially
indexing. An Exchange Traded Fund, generally possess the entire features of a mutual
fund with one additional feature of being traded like a common stock on a stock

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exchange and hence, it is many times referred as a hybrid mutual fund. ETFs
essentially are index funds (but not same) and is tied to a commodity, security or an
index with an aim to closely replicate the possible performance of its underlying. In
other word it can be said that an ETF is a basket that can contain stocks, bonds,
currency, commodities, money market instruments, derivative instrument or any other
security or index. The focus of ETFs is on the preceding word “Exchange traded”
attached to it as an investor can buy or sell them just like other stocks on stock
exchange during trading hours. Trades can be executed through trading account and
can be held as assets in demat account. Price of ETFs deviates on real time basis
depending upon how the underlying asset fluctuates so in this sense it can be said that
ETF is a derivative product as its’ value is determined by value of underlying.

An exchange traded fund may be termed as hybrid financial product, bearing the dual
features of a stock and an open-ended fund. The advantage to ETFs is that investors
can often purchase them at lower costs than other funds since the management
expenses are spread across the many stakes rather than just one. ETFs gives you
diversification by holding investments such as stocks or bonds under one investment
vehicle making it easier for investors to manage their portfolios as well as taking
advantage of potential tax benefits. ETFs are an open ended funds meaning that new
shares can be created and the fund holding can be increased as the demand for it
increases. When there is difference between the price of an ETF share and its’
underlying securities, arbitrage comes into play to reconcile the Net Asset Value of
shares. If the demand for an ETF decreases, the shares are redeemed and the
underlying securities are being sold. ETF allows investors to invest with the fraction
of the cost and get exposure to particular security. For example, if one wants to invest
in NIFTY 50 index which means one needs to purchase entire 50 stocks which may
cost you a lot instead one can buy an ETF tracking NIFTY 50 with fraction of its’
cost.

A disadvantage is that investors do not own actual shares of the fund. This can make
ETFs more difficult for some investors who are uncomfortable with the idea of not
being able to sell their shares at a certain time or as they would with other types of
investments. For this reason, before investing in an ETF, it is important that you
understand all the risks associated with holding it and any tax consequences if you
choose this type of investment over more traditional options like stocks. ETF is
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obliged by law to submit a prospectus, which enlists its’ stocks and sets out its’
investment goals thus creating the transparency which allows investors to understands
clearly what are the risks associated and what returns one can expect when they invest
in ETFs.

Thus in the nutshell it can be said that an ETF is essentially a marketable security
represented as a basket of security replicating the performance of its underlying be it
an index, stocks, bonds or commodity and are bought and sold like single stocks over
an exchange any time during the day. Most ETFs are passive investment instruments
that closely track an index. Being passively managed makes ETFs expense ratio far
less than that of mutual funds. Apart from low cost, ETFs also offers increased
transparency, no entry and exit loads and increased liquidity with its’ in kind creation
and redemption process.

1.2 HISTORY OF EXCHANGE TRADED FUNDS

The history of Exchange Traded Funds has its’ emergence from the stock market crash
of 1987. On October 1987 the Dow Jones Industrial average fluctuated down side by
508 points, with a loss of around $500 billion in assets, which was the second largest
percentage decline over one day in stock market history. This day is better known as
“Black Monday”. Four months later, on February 1988, the SEC (Securities Exchange
Commission) presented a question about what would have been happened if there was
a market basket instrument that could have absorbed the shock to the individual
securities underlying the standard & poor’s 500 Index (S&P 500) ?. It further added
that if an exchange would propose such an instrument based on S&P 500, it would
receive a quick approval.

According to Gary Gastineau, author of “The Exchange Traded funds Manual” the
first actual attempt to produce something like ETF was made on 12th may 1989 when
Chicago Board Options Exchange (CBOE) filed its Value Index Participations (VIPs)
with SEC which were designed to allow investors participation in the performance of
the portfolio of stocks that make up the indexes. But unfortunately in a lawsuit by the
Chicago Mercantile Exchange and The Chicago Board of Trade a federal court in
Chicago ruled that the working of fund was quite similar to that of futures contract
even though they were collateralized and marginalized like stocks if they were to be

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traded, it had to be done on futures exchange as such they felt that Commodity
Futures Trading Commission (CFTC) should regulate the new products and not the
SEC and hence the advent of a truly characterized ETF was delayed a bit. The next
attempt of creating similar product was made in 1990 with introduction of Toronto
Index Participation Shares, which tracked the TSE 35 index and later the TSE 100
stocks.

With a halt of three years after it, on 22nd January 1993, the State Street Global
investors released the S&P 500 trust ETF named as “SPDR or Spider for short, which
is still one of the most popular ETF and is the largest ETF in the world by market
capitalization of 414.46 billion USD. In 1996 Barclays Global Investors introduced a
mutual fund structure for their World Equity Benchmark Shares (WEBS), an ETF that
tracks the performance of foreign market indices. Following the same many ETFs
were floated such as the DOW Diamonds based on Dow Jones Industrial Average in
1998 but the ETF Market experienced boom in 1999 with the launch of NASDAQ
100 Index Trading Stock called as cubes or Qubes with reference to its’ initial ticker
QQQ which had a daily average of around 70 million shares being traded in its’
second year of trading, which stood roughly around 4% NASDAQs’ trading volume.
The Vanguard group entered the market by launching Vanguard Total Stock Market
ETF in 2001 followed by the launch of first currency ETF the Euro Currency Trust
by RYDEX (now Invesco) which tracked the value of euro. The first leveraged ETF
was issued by ProShare in 2006. Considering the gold ETF, its’ first form was Central
Fund of Canada founded in 1961 listed in Toronto stock exchange and American
Stock Exchange.

In Indian context, Benchmark Mutual Fund were the pioneers, the first ETF was
launched in India by Benchmark Mutual Funds in 2001 named as The Nifty
Benchmark Exchange Traded Fund (Nifty BeES) which is listed on NSE and tracks
the Nifty 50 Index. It was a revolutionary step at that time as the investors gained
exposure to the whole index and maintained a diversified portfolio with a single effort
low cost and without an active fund manager. Nifty BeES was followed by the
introduction of first debt or fixed income ETF in 2004 by Benchmark Mutual Fund
named as Liquid BeES. It was introduced keeping in mind the needs of conservative
investors and gave them access to money market. Soon after debt ETF, in 2007, the
AMC introduced the first Gold ETF called Gold BeEs. Initially gold ETF were not
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very popular but its popularity surged extensively between 2008 to 2013. This was
mainly because of global credit crisis of 2008 which made individuals to look after a
safer haven and gold being a safe asset, most of the money was moved into Gold ETF
and in fact they acquired more than 50 % of the market share of total ETF for the
period of 2009 to 2014. However, the very first major boost to ETFs was seen as
soon as ETFs got recognition as an eligible asset class for the pension funds in the
budget of 2013. Further in addition to provide ETFs similar fields as of mutual funds
the securities transaction taxes were also lowered.

The recent ETF introduced is the Bharat Bond ETF April 2030 and BHARAT Bond
ETF April 2023 both were launched in December 2019 and Bharat Bond ETF April
2025 and Bharat Bond ETF April 2031 introduced in July 2020 respectively. This was
followed by HDFC Banking ETF, ICICI Prudential Alpha Low Vol 30 ETF, and
ICICI Prudential IT ETF which were launched in August 2020, UTI Bank Exchange
Traded Fund in September 2020, SBI ETF IT and SBI ETF Private Bank in October
2020 and Axis Banking ETF and NIPPON INDIA ETF NIFTY CPSE BOND PLUS
SDL – 2024 in November 2020 respectively.

From a mere 78 ETFs (gold and others) in March 2019, there has been progress to
106 ETFs, 11 Gold ETFs, 3 International indices and 92 Other ETFs (that track
various debt and equity indices) with total assets under management being Rupees 3.6
lakh crores as of September 2021. There are 166 ETFs listed on NSE as on 31st
December 2022.

1.3 GROWTH OF EXCHANGE TRADED FUNDS

Before the birth of ETF mutual funds were in existence and the first open ended
mutual fund in the US was launched in 1924. Mutual funds democratized the access
of commodities, stocks and bonds globally to common investors. Wells Fargo and
American National Bank, in response to the suggestion of academic research
suggesting the need and importance of passive investing, launched Index Mutual fund
in 1973 for institutional customers. John bogle , who is considered as mutual fund
legend, followed up couple of years later by launching the first public index mutual
fund called the First Index Investment Trust on 31st December, 1975. This fund
tracked S&P 500 and started with just $11 million as assets. This fund was referred to

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as “Bogles’ folly” in a sarcastic way by some. Once it became clear that the investing
publics were interested in such funds the race began and the real world existence of
ETFs was conferred in early 90s with the Index participation Shares and S&P proxy
that traded on American Stock Exchange and Philadelphia Stock Exchange. It was not
a long wait and first ETF began trading in January 1993 with SPDR or Spider with
first of its’ kind and still is the most actively traded ETFs today.

Globally, from one ETF in 1993 the market for exchange traded funds increased to
102 funds in 2002, 291 ETFs in 2003 and nearly 1967 ETFs by the end of 2009. This
trend kept on going and in 2008 the number almost doubled up to 3336 which again
double folded to 7602 ETFs on 2020 and as of October 2021 there are 8,303 ETFs
globally which if compared to as of 2010 is almost an increase of 235.34%. Global
ETF assets in US $ Billion stood at US $ 212 billion on 2003 which was further
recorded at US $ 580 billion on 2006, the growth continued to almost three fold in
2018 to US $ 4,685 billion and as on October 2021 it is at US $ 9,729 billion which if
compared to as of 2010 showed an increase of almost 640.97% in last decade.

Figure No. 1.1 : Global ETFs and ETF Assets

Source: ETFGI data sourced from ETF/ETP sponsors, exchanges, regulatory filings,
Thomson Reuters/Lipper, Bloomberg, publicly available sources, and data generated
in-house.

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1.4 THE INDIAN SCENARIO

Once the ETFs was introduced globally, nearly after decade India saw its’ first ETF
named Nifty BeES, launched by Benchmark Mutual fund in 2001 which tracked the
Nifty 50 Index. Since then the ETF industry in India kept on Growing but at a slow
and steady pace. The Benchmark Mutual Fund continued to be the pioneer of Indian
ETFs and launched the first fixed income ETF named Liquid BeEs in 2004, followed
by first gold ETF, Gold BeEs in 2007. With a halt of 3 years from the last advent, on
2011 the Benchmark mutual fund sold its’ business to Goldman Sachs who further
sold it to Reliance Mutual Fund in 2015. There was a period when ETFs gained
popularity when they were linked with a way to invest in gold from 2009 to 2014. As
a result of credit market crisis of 2008 investors began to look after a safe haven to
invest in, hence gold ETF being the one gained popularity surge. In fact more than
50% of total ETF assets were in Gold from 2009 to 2014. In 2009 the market share of
gold ETFs were around 51% and in 2013 this market share increased to 88% which
means most of the money in ETF market was pooled towards gold ETF. But in 2014
some changes were introduced by government towards supply and demand side of
ETFs. In Budget of 2013 government reduced the securities transaction taxes (STT)
on mutual fund redemption of ETF scheme to 1 rupee from Rupees 250 per Lakh and
on non-redemption of ETF scheme the tax was brought down to rupees 1 from rupees
100 per lakh. As an another milestone in 2014 government introduced CPSE ETF
which invested in bonds of Central Public Sector Enterprises with an aim to raise the
money by divesting their share in public sector undertaking via ETFs. In 2017 Bharat
22 ETF was launched and in 2019 a tax deductible 80C variant of CPSE & Bharat 22
ETF were introduced.

On the other hand, EPFO announced that it would take equity exposure only through
ETFs route starting with minimal of 5% flows which was later hiked to 15% in 2017.
Specific diversification norms for index funds and ETFs were circulated in January
2019 by SEBI. These norms mandated a minimum 10 stocks in an ETF, restricting the
individual stock weight to 25% (or 35% for a thematic ETF) and top 3 weights to
65%. Aiming at liquidity few other rules were also introduced. Lastly, India launched
the first corporate bond ETF in December 2019, following a series of policy moves,
including the cabinet approval, SEBI’s norms for debt ETFs, and the reserve bank

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tweaking its norms to allow debt ETFs to be eligible as collateral for repo
transactions. With this decision a chunk of money rapidly moved to ETFs in recent
years which are set to increase in coming years.

Figure No. 1.2: Indian ETF Evolution

Source: A report on Indian Exchange Traded Funds Industry, A CFA Society India
Research and Advocacy Initiative
It is clearly visible from the above graph that AUM of ETFs in India has shown a
multiple fold increase since the inception of these funds. The composition of gold
ETF was much higher in comparison to total ETF till 2014, since then the sudden
surge in the popularity of ETF increased the proportion of ETFs other than Gold
specially the index ETFs and as of today almost 90 % of ETFs are Index ETFs.
Considering the actual data the total AUM of ETFs stood at rupees 15,000 crores
which surged up to approximately rupees 80,000 crores in 2018 followed by crossing
the mark of approximately rupees 1,50,000 crores and approaching to rupees 2,90,000
crores by march 2021. The AUM of ETF has almost doubled from rupees 1,54,000
crore at the beginning of financial year 2021 to Rupees 2,90,000 crore at the end of
financial year 2021.

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 Figure No. 1.3: Growth of ETFs Over The Decade

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Source : AMFI DATA (numbers as on September of every month )

Over the period spanning September 2019-20, the share of ETFs in the overall mutual
fund industry has increased from 6% to 7%. After examining the bigger picture, it
can be noticed that the ETF landscape has grown and turned vivid from 2014 to the
present as compared to the period before. Asset under management for the ETF grew
from rupees 15,000 crores in September 2015 to Rupees 2,18,820 crores in September
2020- which is 14.45x (or 1345.77%) in a mere time duration of only 5 years, at a
CAGR of 70%. A major part of this growth can be attributed to equity and debt ETFs
as against Gold ETFs. The share of gold ETFs in the total ETF composition remained
high from 2009 (51%) to 2013 (88%), while the other ETFs (equity & debt) were still
gaining momentum. From 2014 onwards, the share of equity and debt ETF picked up
the pace and went from 39% in 2014 of total ETF AUM to as high as 93% in 2020.

Figure No. 1.4 : Performance of Exchange Traded Funds

Source: NSE tweet as on 7th January 2021.

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Exchange traded funds saw transactions by 32.2 lakh investors in current year 2020, a
leap of almost 200% over 2019, maintaining the growth trend for 5th consecutive year
since 2016. The Average daily turnover of rupees 241 crores also increased by 15% in
current year 2020 as compared to that of 2019 (NSE).

1.5 MAJOR CATEGORIES OF EXCHANGE TRADED FUNDS

An ETF as the name itself suggests is a basket of securities that usually has a tracking
behavior of indices. These indices are developed to monitor a particular sector or asset
classes instead of a single stock hence allowing the feature of diversification to float
within and thus strengthening the portfolios. Some of the major categories of ETFs
are enumerated below.

 Index ETFs- Index ETFs are the passively managed ETFs which track a
benchmark index with objective to mimic their performances thus providing
investors with exposure to all the securities included in the index with a single
transaction. For example suppose one needs to invest in NIFTY50 index which
means one needs to purchase all the 50 stock instead one can buy one share of
such Index ETF and easily invest in it.

 Commodity ETFs- As the name itself suggests these ETFs holds physical
commodity such as gold, silver and other precious metals or combination of
investments in a physical commodity along with related equity investments
administering future trade.

 Bond ETFs- Bond ETFs are the ETFs that invest in a specific fixed Income
securities or bonds with different investment strategies. These bonds can be short
or long term government bonds, corporate bonds or emerging market bonds etc.
For example, G-Sec Long term ETF, SBI ETF 10 year Gilt are some of the bond
ETFs in India.

 Sector ETFs- These types of ETFs generally track an index representing a

particular sector. They invest in stocks and securities of specific sectors identified
as per the objectives of the fund.

 Currency ETFs- It is a pooled investment that helps investors to adhere exposure

to currencies of other countries without involving in complex transactions. These

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 are simple investment prop that tracks foreign currencies and are generally
affected by interest rate changes, political decisions, global economic conditions
and other factors.

 Actively managed ETFs- Actively managed ETFs are those which are managed
by a team of manager or manager making the decisions and they do not follow a
passive investment strategy. These funds bear the features of traditional ETFs but
with a fund manager who manages the fund in order to enable the fund to adapt to
market changes. Thus producing the returns that may or may not match the
underlying asset.

 International ETFs- International ETFs invest in securities based out of the

country. They are less risky as compared to those ETFs which invest in single
foreign countries as they may get affected by the internal fluctuations of that
country. Increasing globalization has led to increase in popularity of such ETFs.
They bear a higher expense ratio because of higher cost of investment abroad.

 Leveraged ETFs- leveraged ETFs use debts and financial derivatives to multifold
the returns of their underlying. Unlike traditional ETFs they instead of tracking
index on one to one basis they aim for certain specific ratio. They are created with
the aim of pricing a leveraged return on underlying.

 Inverse ETFs- Also known as short ETF or bear ETF it is an index ETF which
gains value when its’ correlating ETF loses its value. It is created using different
derivatives to generate benefits from decline in an underlying benchmarks’ value.

Recently ETFs in India, After 19 years crossed a new mile stone by getting 100th ETF
listed on NSE. The first ETF was listed over NSE on 8th January 2002 witnessing
trading of rupees 1.30 crores of trading on NSE. Currently in India, ETF listed on
NSE are categorized into four categories i.e. Equity ETF, Debt ETF, Gold ETF and
International ETF. As of December 2021 there are in total 106 ETFs listed on NSE
which comprises of 11 Gold ETFs, 3 International ETFs and 92 Equity and Debt
ETFs. During current financial year the average daily turnover of ETFs on NSE stood
at around rupees 265 crores. A growth of 96% has been recorded in the number of
transactions from investors in ETFs from 20.4 lakhs in financial year 2020 to 40.1
lakhs in financial year 2021 and already there has been more than 22 lakh transactions

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by investors in first quarter of financial year 2022.

1.6 FUNCTIONING OF EXCHANGE TRADED FUNDS

Unlike traditional mutual funds, an ETF trades on a stock exchange like a common
stock. As it is purchased and sold on the stock exchange, the trading price of an ETF
fluctuates throughout the day, just like any other stock. The net asset value of the
underlying stocks that an ETF represents determines its trading value. This means that
it is possible to take long and short positions; market limit or stop orders can be
executed and it can also be purchased on margin. Talking about the mutual funds, the
case is straight forward; the AMC takes your money, buys the securities and discloses
the NAV at the end of the day and vice-versa. But in case of ETFs there exists a
unique creation and redemption mechanism which makes it different and as it is
traded over stocks it is just like an exchange of units between buyer and seller. Before
proceeding to understand the entire process there are some terminologies that one
should know

 MARKET PRICE – Just like NAV is associated with mutual funds in similar
way market price is associated with ETFs. It is called market price as it is
determined by market forces of demand and supply and trading activity over the
exchange. In order to determine the fairness of the price, as an investor one is
paying, the role of NAV is important.

 NET ASSET VALUE (NAV) - NAV tells the total value of funds’ assets and
yours. It is obtained by deducting all expenses from the value of all assets and
dividing it by number of shares. NAVs are announced at the end of the day
whereas ETFs trade on real time basis. Again the question arises about whether
the price is fair in real time or not. Here come the iNAV on play.

 INTRADAY OR INDICATIVE NAV (iNAV)- In order to verify the fairness of

the market price, which investor sees on their trading platform a reference point is
needed. iNAV serves this purpose and is calculated by AMCs every 10-15
seconds which is displayed on their websites. This iNAV is obtained by adding
cash component to the multiplication of number of shares in ETF creation basket
and last traded price of all the securities in ETF basket and then the value so
achieved is divided by total ETF shares in creation basket.

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 CREATION UNITS- It refers to the representative basket of securities exactly in
the proportion same as of their underlying. The size of creation units is specified
by the AMCs.

 MARKET MAKERS AND AUTHORISED PARTICIPANTS- As ETFs trade

on real time over the exchanges liquidity becomes an important characteristics of
ETF ecosystem and so as the role of market makers and authorized participants.
The role of these guys is to provide continuous liquidity by providing two way
quotes on exchange meaning buy at bid and sell at offer and the difference
standing as their profit.

 PREMIUMS AND DISCOUNTS - The price of ETFs generally remains in

alignment with their NAV but sometimes due to volatile phases of market the
price may tend to trade away from NAV. If the price is more than its’ NAV it is
called premium and if the price is below NAV it is called discount. However this
situation gets rebalanced quickly.

 TRACKING ERROR- Tracking error shows how closely an ETF is tracking its’
underlying. It technically refers to the annualized standard deviation of the
difference between the returns of ETF and the underlying it tracks. It is sometimes
also called active risk. The lower the tracking error, the more closely the fund
follows its underlying and vice-versa.

With above terminologies in mind one can now understand the working of exchange
traded funds. ETFs are created by a fund sponsor, who determines the ETF's
objectives and target index, as well as the securities that would be included in the
securities "basket" and the number of ETF shares which will be issued to investors.
Market makers and institutional investors can deposit the stock basket that comprises
an index with the fund trustee and receive fund shares in return. The shares obtained
can then be exchanged as stocks on a stock market or redeemed for a stock basket,
which then becomes the underlying index. The intriguing aspect of this operation is
that, even though the index composition has changed in the meantime, the
performance obtained by an investor who generates new shares and then redeems
them is equivalent to the index return fees.

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The creation and redemption mechanism is significant for a number of reasons. For
one thing, you don't have to buy an ETF on the stock exchange all of the time. If
you're buying in multiples of the creation unit size, buying directly from the AMC is
the way to go because buying large amounts on the exchange can result in liquidity
concerns and effect expenses. Arbitrage is the second reason why ETF formation and
redemption mechanisms are significant. ETFs can trade at premiums and discounts to
the NAV, as explained previously. Market makers are critical players in the ETF
ecosystem because they are in charge of adjusting premiums and discounts. This is
achieved through the creation and redemption procedure.

Figure No. 1.5 : Creation and Redemption

Source: NSE

1.7 THE STORY OF CREATION AND REDEMPTION

It is important to understand that while ETFs trade like stocks they differ from stocks
in many ways. One of the major differences is supply. Stocks have a limited supply
available to investors as a result large trades may result in increase in prices of stocks
due to high demand. On the other hand the supply of the ETFs can be increased or
decreased on demand. This unique feature provides liquidity to ETFS which means
one can buy and sell the ETF units when they wish at a price close or equal to its’
underlying.

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To start lets understand the metaphor of flower. Imagine that an individual stock is a
flower, just as companies come from different sectors, flowers are in different shapes
and sizes and when it is bundled according to a specific recepie (i.e., an Index) then it
becomes an ETF. Further, the ETFs derive their price from the price of individual
stocks contained in it. So when the price of stocks fluctuates so does the price of ETFs
too. Now the bundle of flower represents the ETF, Individual flowers refers to
individual stocks, flower shop owner refers to brokers. Now that the picture is clear
lets understand the process.

Say an investor (customer) wants to buy an ETF (bouquet). He goes to shop browses
the menu and decides that he wants bouquet of specific recepie. The florist i.e, broker
takes the order tries to complete order by purchasing flower from flower market i.e.
stock market and investor pays the money to the broker (i.e., florist) and gets the order
delivered as he wanted. This was the simple scenario. Now moving to creation of
ETFs, what if instead of one single order, if investor wants to purchase or place order
for say 100 or 200 units. Just like early the broker tries to complete the order from
stock market but there arises one problem that order items are limited in number. Here
comes the role of authorized participants. Thanks to unique process of ETF creation
more such units can be created. In order to manage the demand and supply the
authorized participants keeps a close eye on market. Now since the market makers
cannot fulfill the order, the authorized participants does the same by checking the
index and finding out exactly which stocks make up that index ETF. Then the market
makers provide the stocks to the authorized participants which make up the ETF. All
such stocks are forwarded to the workshops i.e., Asset Management Companies; the
AMCs assemble them to form such required ETF, once it is ready they are handed
over to authorized participants and they hand it over to the brokers who in turn fulfills
the order at market price. Interestingly despite of the size of the order the price of the
ETFs remain approximately the same and the entire process is performed hassle free.
Investors just have to place the order and the process gets kicked in as and when
needed.

On the reverse side of the same redemption happens when an investor wants to sell
his ETF holdings. Investor returns his holdings to the broker who forwards it to
authorized participants who then handles it over to AMCs, where the stocks are
disassembled and individual stocks are handed back to authorized participants who in
turn circulates them in the stock market and just like that supply and demand comes in
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line. In the ETF mechanism, as in the case of traditional mutual funds, the number of
units created is not limited, if investors demand and are willing to deposit an ETF
basket, the fund sponsors can create an unlimited number of creation units and ETF
holders can redeem the underlying shares by surrendering the shares to the trust. The
surrender of creation units approximates the proportion of the underlying index plus a
cash component. This "in-kind" creation/redemption process ensures that the ETFs
always trade at or near their fair value. As a result, ETF units are created and
redeemed on a regular basis, depending on investor or market demand. The units can
be used for investment, trading, or arbitrage by the buyer. If the value of the
underlying index exceeds the price of the ETF, investors may return the units to the
sponsor in exchange for the higher-priced securities. Investors can also create ETF
units by depositing lower-priced assets if the underlying securities' price is lower than
the ETFs'. This arbitrage mechanism assists the ETF in maintaining a close
relationship with its underlying Index.

Figure No. 1.6 : Creation and Redemption of ETFs

CREATION OF ETFs
AUTHORISED PARTICIPANTS
SECONDARY MARKETS

EXCHANGE TRADED
APs buy the creation basket APs deliver the creation basket

FUNDS (IN KIND

(Stock exchange)

EXCHANGE)
Containing underlying securities containing underlying securities

APs sells ETF shares in market APs receives new ETF shares

(Secondary markets) (Creation units)

REDEMPTION OF ETFs
AUTHORISED PARTICIPANTS

EXCHANGE TRADED FUNDS

APs delivers ETF shares

APs buys shares of ETFs’
SECONDARY MARKETS

(IN KIND EXCHANGE)

to fund
(Stock exchange)

APs sells ETFs’ APs receives portfolio of

underlying securities on the ETFs’ underlying
the stock market securities

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In general the market forces are active to keep the bid and ask price close to the NAV.
Whenever the market price of ETF and NAV starts to differentiate significantly, there
is a chance of arbitrage. Considering this opportunity of profit from such price
difference the authorized participants may either create or redeem the ETF units and
because of this arbitrage process the market price and its’ NAV are closely aligned

Figure No. 1.7 : Arbitrage Process of ETFS

If ETF price > NAV (i.e. Value of basket of If ETF price < NAV (i.e. Value of basket of
securities) securities)

AUTHORISED PARTICIPANTS: AUTHORISED PARTICIPANTS:

Buys index basket on market Buys ETF on market
Exchanges index basket for new ETF units Exchanges ETF units for the index basket
(i.e. creation of units ) (i.e. redemption of units )
Sells ETF on market Sells index basket on market

The price of an ETF approaches that of NAV value

making the spread very tight

1.8 ADVANTAGES OF EXCHANGE TRADED FUNDS

ETFs can easily be characterized by number of attributes contained in it. While many
investors have similar outlooks, no two are identical. Because of its unique structure
and in kind creation and redemption feature, any investor whether institutional or
retail can benefit out of it without any or minimum disadvantage. It allows long term
investors to diversify their portfolio at a very cheap cost and keep them for short term
trading. ETFs inhibits some common advantages such as high intraday liquidity and
having no minimum purchase requirements etc. some of the important advantages are
as follows

 DIVERSIFICATION- ETFs looks like stock but resembles mutual funds in

many ways. Just like mutual funds it has many numbers of securities underlying
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 which provides them built in diversification thus safeguarding the portfolio
against severe negative impacts on returns from any one holding.

 STOCK LIKE TRADABILITY- Just like stocks ETFs can be traded over stock
exchanges thus providing ease of intraday purchasing and selling at prevalent
prices. A stock like tradability enhances the ability to execute orders such as
market orders, limit orders, stop loss orders, margin purchase and short selling.

 LOW COST- The cost associated with ETFs i.e., expense ratio is as low as
0.01% to 1% as compared to other Index funds which has an expense ratio of 2-
2.5 %. A lower fund management fee indirectly leads to increased pay outs. Not
having any subsidy costs, or cost of flow, ETFs provide an added advantage over
and above mutual funds.

 TRANSPARENCY- Transparency and applicable costs is essential to evaluate

and invest in any fund. It helps in choosing the appropriate fund for investment.
When compared to ETFs, hedge funds and even mutual funds are less transparent.
Hedge funds, institutional investors, and mutual funds typically declare their
holdings only quarterly, keeping investors in the dark about whether the fund is
sticking to its stated investment plan and managing risks appropriately. ETFs, on
the other hand, typically reveal their daily portfolios, allowing investors to keep a
better understanding of how their money is being invested.

 LIQUIDITY, ARBITRAGE AND PRICE DISCOVERY- ETFs are more

liquid than mutual funds, which can only be bought or sold at their end-of-day
closing price, because they can be bought or sold in secondary markets throughout
the day. They normally trade near their true Net Asset Value because their
creation/redemption process regularly balances out pricing arbitrages, bringing the
price of ETF shares back to fair market value.

 TAX EFFICIENT- Because ETFs are structured to reduce capital gains tax, they
are tax-efficient. Individual investors in a mutual fund must pay capital gains tax
if the fund sells some of its assets for a profit, even if the fund as a whole loses
value over the year. Because the underlying securities are effectively owned by a
third party, an individual investor who owns shares of an ETF is not liable for
capital gains tax if the fund sells them for a profit. When an Authorized

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 Participant (AP) creates or redeems shares of an ETF, it engages in an in-kind
exchange with the ETF sponsor rather than a monetary transaction.

 EFFICIENT MARKET HYPOTHESIS- No fund manager can outperform the

market indefinitely, according to the Efficient Market Hypothesis, and
outperforming techniques are swiftly duplicated and arbitraged away. As a result,
passively investing in the entire market tends to beat active stock selecting in the
long run. ETFs are a better offering than actively managed funds if you believe in
this financial theory.

 ELMINATION OF MANAGER RISK- An Exchange Traded Fund does not

rely on active investment calls from a fund manager because it tracks an index. As
a result, any mistakes made by a fund manager have no bearing on it. It may
occasionally have a tracking error when tracking the index, although this is
usually minor and can be ignored.

 TRACKING ERROR- Due to decreased expenditures and the unique in-kind

creation / redemption procedure, tracking error, or the difference between the
ETFs' NAV and the underlying Index, is typically noted to be minimal when
compared to a traditional index fund.

 UNIQUE IN KIND CREATION AND REDEMPTION- Unlike listed closed-

ended funds, which trade at significant premiums or, more commonly, at
discounts to NAV, ETFs are structured in such a way that Authorized Participants
and Large Institutions can create new units and redeem existing units directly with
the fund, ensuring that ETFs trade close to their actual NAVs.

1.9 DISADVANTAGES OF EXCHANGE TRADED FUNDS

 GIVING UP THE ABILITY TO OUTPERFORM- an actively managed funds

can outperform the market and give you a better return especially in markets like
India. But ETFs are mend to mimic their underlying and even if they tend to
outperform the market forces, existing arbitrage and creation and redemption
process ensures that they bounce back. Hence an investor gives up the ability to
outperform.

 VOLATILITY- The underlying which an ETF passively tracks can be liquid or

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 volatile depending upon the condition. Hence one needs to first understand the
volatility front of underlying

 FEES AND COSTS - ETF costs are sometimes considered to as a benefit rather
than a disadvantage. In some cases, such as when compared to mutual funds, this
is true. ETFs do, on the whole, offer reduced fees and charges, but they are not
free as separate products. You'll have to pay a fund manager (or several) to handle
the holdings because they're not completely passive. By managing equities on
their own, savvy traders can avoid the fees associated with ETFs.

 COMMISSION COSTS- Because ETFs are traded like stocks, each purchase of
an ETF incurs a commission fee. This means that investors who invest tiny
amounts of money every month or so will see sales load eat away a considerable
portion of their investment money. ETFs are thus only a good option if the
investor is making a one-time, lump-sum investment.

 DIVIDEND DRAG - The inability to reinvest dividends is another disadvantage

of ETFs that may have a minor impact on their market performance.

 PREMIUMS AND DISCOUNTS - An exchange-traded fund (ETF) may trade at

a discount to its underlying assets. This means that, even if the companies are
performing well, the ETF may be trading for less than the market value of these
stocks.

 OTHER RISK EXPOSURES - All investments involve certain types of risks

and ETFs are no exceptions. Some risks that an ETF may be exposed to, is
tracking error, market risks, credit risks and interest rates risks etc.

The other disadvantages associated with ETFs trading includes tracking error,
liquidity, brokerage on dividend reinvestment, capital gains distribution etc. but are
not of much significance as market forces are highly active in emerging market and
they tend to almost eliminate the effect of such drawbacks.

1.10 STATEMENT OF PROBLEM

India's mutual fund business has risen at a rate of 12.5 percent per year on average
over the last ten years, beating the rest of the world and developed regions by more
than twice. On November 30, 2021, the domestic mutual fund industrys’ asset under
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management (AUM) exceeded the Rupees 37,33,702 crores mark. For the month of
November 2021, the Indian mutual fund industrys’ average assets under management
(AUM) was Rupees 38, 45,378 crores.

Over the last three years, the Figure Number has more than doubled, from 16.50
trillion in November 30, 2016. SEBI, as a market regulator, has taken initiatives in
recent years to promote mutual fund penetration in smaller cities. These appear to be
paying off, since the number of new folios is rapidly increasing, as is the percentage
of smaller city assets. During the month of May 2021, the mutual fund sector reached
a 10-million-folio milestone.

It is not enough to boost the savings rate to accelerate our countrys’ economic
development, one must also improve the savings' holding pattern. Savings in the form
of cash or tangible assets sit idle, unproductive, or underutilized. The government's
involvement in financial savings is one of the primary contributions of rapid
economic development. Savings have recently drifted away from physical assets like
gold and real estate and toward financial products, and this trend is unlikely to
change. In India, mutual fund AUM is 15% of GDP, compared to 75% globally,
indicating that there is room for exponential expansion. The mutual fund industrys’
AUM has increased at a CAGR of 20.6 percent over the last five years, while equity-
oriented AUM has expanded at a CAGR of 25%. Because investing in equity shares is
too perilous, ETFs are a way for investors to pool their funds and invest in a variety of
markets and securities. ETFs are well-known in most developed financial markets,
although they are new to Indian investors. The poor investor knowledge and financial
literacy in semi-urban and rural areas is a difficulty for the ETF sector. Many
investors have been hesitant to enter the stock market because of high new issue
pricing, problems appraising a company's prospects, and dropping market share prices
after listing. For small investors, the secondary market had become extremely volatile
and technical. Real estate, stock markets, derivatives, and other assets are all
extremely volatile. In order to invest in corporate securities, investors must grasp the
markets’ intricacies, maintain track of market fluctuations, and make scientific
investment judgments. The growing popularity of Exchange Traded Funds (ETFs)
demonstrates that in todays’ complex and sophisticated capital market, an ETF is a
suitable investment vehicle for small investors with limited knowledge and
information. Individuals who want to invest but don't have the knowledge, expertise,
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or money to diversify their investments across multiple industries can use the ETF as
an alternative. Despite the fact that the ETF market is expanding, there is still plenty
to be done.

The current work is an attempt to bridge the gap and assist investors in making
worthwhile investments. As a result, the current study aims to list the benefits of ETFs
to small and medium investors. ETFs are projected to offer the benefits of diversity,
market timing, and tax savings among the numerous types of mutual fund schemes.
An ETF is the ideal way to invest money since it allows you to sell it at real-time
pricing rather than waiting for the price at the end of the day. As a result, the
researcher plans to investigate the ETFs’ performance and tracking capabilities. In
terms of the scale of mobilized money and the number of schemes on the market, the
ETF business has exploded in recent years. It was thought that evaluating the
performance of Indian ETFs using a variety of popular performance measures was
important.

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