So far, if you did not know what ETFs meant, it was fine. But the way things are going, you will surely need to know what they are.

ETFs (Exchange Traded Funds), have already become extremely popular investment vehicles in developed markets, though back home they are yet to make any tangible headway. But the good news is that the Budget proposal to allow mutual funds to invest in global ETFs ushers in a whole new investment universe for Indian investors.

Globally, there are around 400 listed ETFs. More than 60 per cent of trading volume on the American Stock Exchange is in this category of funds.

The popularity of ETFs abroad is not out-of-place -- the performance of many of these funds has been nothing short of incredible. For instance, over the last 12 months, the iShares Morgan Stanley Composite Index (MSCI) ETF based on the Brazilian market,recorded 86.15 per cent returns while the iShares S&P Latin American 40-stock ETF listed on the same exchange appreciated 76.66 per cent during the period.

Compared to this, the five home-grown index-based ETFs delivered an average return of 35.35 per cent for year ended March 16, 2006, though actively managed funds in the country have fared far better with an average return of 43.31 per cent during the same period.

"Since actively managed funds deliver better returns in India, investors prefer them to index-based products which include ETFs," says Rajat Jain, chief investment officer, Principal PNB Mutual.

True. Indian investors have hardly been enthusiastic about ETFs so far. While the average daily volume for the top 10 active ETFs in the US was about 2.73 crore (27.3 million) units in the last three months, the average daily traded volume in India has been a measly 18,000 units during the whole of last year.

But going forward, if one has the option to invest in fast growing markets like Brazil and Russia, ETFs may be tough to resist, especially if Indian markets become more expensive.

Already, some fund houses like Benchmark Mutual and UTI Mutual have expressed their intention to launch schemes that would invest in global ETFs.

"We would be keen to launch funds that would invest in global ETFs soon," says Rajan Mehta, head of sales, Benchmark Mutual Fund, the first AMC to launch ETFs in the country in 2001. Besides, Benchmark has lined up some nine sectoral ETFs to be launched in phases in the coming months.

One reason why ETFs have not taken off yet is that it is tough to understand how these funds work. But just like you don't need to understand the principles underlying internal combustion engines to drive a car, you need not understand the complicated back-end mechanisms of ETFs to invest in them. It's enough to know how this investment vehicle can take you to your final destination.

For those who have never heard of ETFs before, these are essentially index funds that can be traded through stock exchanges. Index funds essentially invest in the basket of stocks that constitute the chosen index and, that too, in the same proportion as in the index. There are over 15 index funds in India, which track the Sensex and the Nifty.

Instead of going to your fund distributor to purchase or redeem units, you need to just place an order with your regular broker to buy or sell units of ETFs through the stock exchange.

There are five ETFs with total assets of Rs 820 crore (Rs 8.20 billion). Of these five funds available today, four are managed by Benchmark Mutual Fund.

At present, the fund house manages four ETFs -- Nifty BeES, Junior BeES, Nifty Bank BeES and Liquid BeES. These funds track the Nifty, Junior Nifty, Bankex and Crisil Liquid index respectively. Besides, there are two other ETFs in the country, one each from UTI Mutual and Prudential ICICI [Get Quote] Mutual.

While UTI Mutual's Sunder, based on the 50-share Nifty, is traded on the National Stock Exchange, the Prudential Spice has been suspended from trading since mid 2005.

Till date, its units have not been re-listed. The creation of units was banned following some bizarre trades executed by some ill-informed investors. The trades created a supply crunch of units that drove market price of the fund's units to over Rs 200 from around Rs 75 in nine days which was not in sync with the underlying index Sensex.

Even though volumes are still very thin, ETFs are a great avenue to invest in for both individual and institutional investors since they seek to minimise risk and reduce costs.

Before we get into the finer nuances of ETFs, here is the fundamental premise of ETFs. Since these are index-based products, their genesis also stems from the Efficient Market Hypothesis which states that at any given time, security prices fully reflect all available information.

What this implies is truly profound. Most individuals, who buy and sell stocks, do so under the assumption that the securities they are buying are worth more than the price that they are paying, while securities that they are selling are worth less than the selling price.

But if markets are efficient and the current prices fully reflect all information, then buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill.

By implications, investors need to look no further than index funds, which promise to deliver average returns. There are experts who argue that emerging markets like that of India are still inefficient and hence active fund management can yield better returns than that of the index. But before we get into that argument, here is how ETFs score compared to open-end index funds.

Unlike index funds, where the fund manager buys or sells the underlying shares constituting the benchmark index as and when money flows in and out of the fund, ETFs work through a special set of first-level intermediaries called Authorised Participants.

In exchange for shares that, in total, mirror the index tracked by an ETF, the APs receive units that they then list on stock exchanges for common investors to buy and sell like stocks. The redemption process is also different. When the APs want to redeem units, they accept a basket of shares in return for units of ETF.

Thanks to this unique process of creation and redemption of units through 'in-kind' transactions, ETFs are able to keep costs low. So, when investors buy and sell ETFs, they aren't creating new shares, neither are they redeeming old shares; rather, they are simply transacting with other investors just as they transact in any stock.

Since mutual funds buy and sell securities in the market, they involve higher costs.

Another plus with ETFs is lower expenses. At present, the expense ratio for index funds is around 100 basis points including the annual fee, while for actively managed funds it is around 2.25 per cent. " Against this, the expense ratio for ETFs ranges between 20and 80 basis points," says Mehta.

"But one also needs to take into account the fact that ETFs attract securities transaction tax (STT) since these are traded through the exchanges." says Principal's Jain. STT has been raised to 0.25 per cent for delivery trades in the Budget. Non-delivery trades attract a STT of 0.025 per cent.

If you were to bet on the market for the short term, ETFs may be a better option, mainly because of lower expenses. Even with the STT, they may still be cheaper as index funds usually charge an exit load of around 1-2 per cent for redemption within six months which makes them unattractive for short-term investors.

Even as you may try to capture intra-day movements in ETFs if you are a day trader, APs act as market-makers for units of an ETF. In other words, the moment there is a difference between the net asset value of the fund and its traded price on the exchange, APs will jump in to exploit the arbitrage opportunity and drive the price closer to equilibrium.

This ensures that ETF units are fairly priced though in the past one year the market price of Nifty BEes has been traded at an average discount of 0.25 per cent. Since ETFs are traded on exchanges, investors can trade in these units at intra-day prices. But in the case of index funds, one can buy units only at day's closing price.

ETFs can also be used as an effective hedging tool. Short-selling is not allowed on ETFs at this juncture, though the Sebi approval is awaited in this respect.

While ETFs can be a good trading tool for small investors, if you are looking to build wealth over as long term, actively managed funds could be a better option. This is because Indian market are still developing and there are hundreds of investment ideas. So, the chances of producing returns higher than the market averages are fairly high if you trust your money with a competent fund manager.

"In India, most active funds outperform the index unlike in the US," says Jain. Over the past 12 months, nearly 40 per cent of the fund managers have beaten their benchmarks.

In absolute number terms, about 160 out of a total of 470 actively managed funds have outperformed the Sensex. However, with the number of mutual fund schemes running into hundreds, the tricky part is to choose the winner. If one does not have the time and expertise to choose the likely front-runner, it's best to settle for the average. No pain, some gain.

Why you can't ignore ETFs Best way to invest in overseas markets. A slew of new launches are coming soon Low tracking error compared with regular index funds due to unique process of creation and redemption of units Management expenses range between 0.20 and 0.80 per cent against 1 per cent for index funds and 2.25 per cent for actively managed funds Can be bought at intra-day prices unlike open-end index funds, which are available only at closing prices Can be an alternative to index future; you can commit lesser amounts When ETFs could be a compromise Convenient to transact; you can buy and sell them through your regular stockbroker Index funds would deliver mediocre returns in a market like India where mutual funds tend to beat the benchmark. But they work well in developed markets where fund managers can't easily beat the market averages

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