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Mutual Fund Scheme Analysis July 08, 2011

Nifty BeES:
Prologue: Exchange-Traded Funds (ETFs) are gaining investors attention due to their transparency, low cost
structure compared to other mutual fund schemes, passive investment strategy, diversification and real time
trading. They are passively managed mutual fund schemes that invest in the securities comprising an index in a
proportion which the securities are present in that index. They are listed and traded on stock exchanges, hence
whose units can be bought and sold on the real time basis like equity shares.

What is an Index Fund? Index funds are passively managed mutual funds that invest in the securities comprising
an underlying index in a proportion which the securities are present in that index. The basic objective of such
schemes to replicate the performance of index which they track so as there is no fund manager risk is involved.
Their NAVs are calculated and declared once in a day like other normal mutual funds.
What is an ETF? Exchange traded funds (ETFs) are a special kind of index funds. They are similar to traditional
mutual funds in all respects like return and risk. Where they differ is where they trade and how they trade. They
are mutual funds however they are bought and sold like shares. Unlike ordinary mutual funds where they can be
purchased or redeemed through respective fund houses, one can buy or sell ETFs units on a real time basis as
they are listed and traded in stock exchanges.
Index funds and ETFs vary from actively managed funds as the actively managed funds make active stock and
sector calls by proper research and analysis to outperform the index. In a nutshell, we can say that the index
funds are meant to give returns by mimicking the index while, on the other hand, the actively managed funds try
to outperform the index (benchmark).
Hence, they are the schemes whether index funds or ETFs that are suited for conservative investors who want
to follow and willing to get returns in line with index returns. However, Investors have to own a demat account
and a brokers account to participate in the investment process of ETF transaction.

Buying index/ETF is a comparatively safer, cheaper and less riskier way of investing.

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Why does one invest in indices (Index Funds or ETFs):

a. Investing in indices is considered as efficient investment option as they include large actively traded stocks
from diversified and performing industries.
b. Indices are revamped periodically representing the changes in the importance of sectors and growth cycle
of stocks. The world changes, so the index should change.
c. Investors benefit out of these changes as they need not take a call on entering or exiting a particular sector
or stock.

Benefits and concerns of investing in ETFs:

ETFs offer several advantages to investors: -

ETFs can easily be bought/sold like any other stock on the exchange and at anytime during market hours. There
is no separate form filling and can be traded by just a phone call. Investors have the ability to put limit orders.
Minimum investment is one unit. Investors can enjoy the flexibility of a stock and diversification of index fund.
One can view the portfolio holding any time one wants whereas portfolio of other mutual funds available once in
a month. Expense ratio is low in ETFs compared to other mutual fund schemes. There is an arbitrage opportunity
available between Futures and Cash Market. Above all, passive funds provide better downside protection than
actively managed schemes during downturns.

Concerns:

Impact cost is higher than its constituents. Transaction costs like brokerage charges need to be paid anyway
when trading in ETFs.

However the benefits far outweigh the concerns.

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History of ETFs:
First ETF came in 1993 on S&P500 called SPDRs.
SPDRs and QQQs (ETF on Nasdaq 100) are the most actively traded ETFs.
Although the first ETFs tended to track broad market indexes, more recent ETFs have been developed to
track sectors, fixed income, global investments, commodities and currencies.
In December 2001, India began its foray into the sphere of exchange traded funds.
Nifty BeES the first Indian ETF, was launched by Benchmark Mutual Fund based on S&P CNX Nifty Index.
At the end of April 2011, as per the ETF landscape report released by BlackRock Inc., the global ETF
industry had 2,670 ETFs with 6,021 listings and assets of US$1,469.8 bn, from 140 providers on 48 exchanges
around the world. This compares to 2,189 ETFs with 4,354 listings and assets of US$1,113.1 bn from 122
providers on 42 exchanges at the end of April 2010. It is expected that the global AUM in ETFs and ETPs to
increase by 2030% annually over the next few years, taking the global ETF/ETP industry to approximately
US$2 trillion in AUM by early 2012.
ETFs vs. Index funds:

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How do ETFs Function?

ETFs vary from normal mutual funds in terms of the functionality, the manner in which they are created, bought
and sold. In normal mutual funds, investors pay cash to the fund house, which in turn buys the securities and
constitutes the fund. In case of ETFs, the fund house appoints market makers in the stock market to execute all
the transactions on behalf of the fund house. The market-makers, also called as arbitrageurs or Authorized
Participants (APs) involve into the following four distinct transactions;

1. The Authorized Participants purchase a basket of shares, as specified by the fund house, for cash.
2. This basket of securities is then exchanged with the fund house for a set number of ETF units (creation).
3. The Authorized Participants then satisfy market demand by doing buy/sell orders (and sell/redeem these
units to investors just like a distributor does).
4. The Authorized Participants are performing an arbitrage between the ETF and index to keep the market price
of the ETF close to its NAV.

The Authorized Participants are empowered to create or redeem ETF units. They buy the basket of securities
(such as all the scrips of the market index as specified by fund house) and hand it over to the fund house, in
exchange of a certain number of units (which are usually 50,000 or a multiple thereof). This process is called
unit creation, whereby ETF units are created in exchange of a basket of securities.
The Authorized Participants then break up these units and sells them separately on the stock exchange. Investors
can then buy and sell these units through the stock exchange.
The Authorized Participants also redeem the ETF units by delivering them to the fund house in return for the
securities represented by those units. Note that the exchange of ETF shares and the securities they represent
between the Authorized Participants and the fund house is an in-kind exchangethere is no exchange of cash.
This also lowers taxes for the ETF sponsor, thereby lowering the funds fees.

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How ETFs work?

Primary market Secondary market

Seller

Cash ETF Units

Authorized Buy / sell

Participants / Stock Exchange
Market making /
FI Arbitrage

Creation Redemption Cash

in-kind in-kind ETF Units

Fund Buyer

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Nifty BeES
Features of Nifty BeES:

First Exchange Traded Fund (ETF) in India.

Combination of a share and a mutual fund unit.
Real-time Trading on NSE.
Real-time Indicative NAV.
Available across NSE terminals.
Tracks the S&P CNX Nifty Index.
Priced at 1/10th of the Nifty Index.
Investment management fees is 0.35% and the total expense ratio is 0.80% per annum, the lowest in India.
Structured as a Mutual Fund under the SEBI 1996 regulations.

Advantages of Nifty BeES:

Simple Can be bought/ sold on NSE like a sharereal-time.

Economical No load scheme. Annual expense is one of the lowest for any mutual fund scheme in India.
Diversification Its a cost efficient way to invest in a basket of securities.
Equitable Structure Long term investors insulated from short term trading activity.
Transparent Investors have access to information on the portfolio constituents represented on a daily
basis.

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Nifty BeES Scheme Details:

NSE Symbol :NiftyBEES.

BSE Code :590103.
ISIN :INF732E01011.
Reuters :NBES.NS.
Bloomberg :NBEES.IN.
Total Expense Ratio :0.50%.
Tracking Error :0.02%*.
Impact Cost :0.11 as on May-2011**.
Issued Cap :96,47,476 (shares) as on 28-Jun-2011.
Market Cap :543.24 (Crore) as on 28-Jun-2011.
52 week high/low price :640.00/527.25.
Entry / Exit Load :Nil.
Note:
*- Tracking Error is calculated based on daily Rolling Returns for last 12 months (Source: NAVIndia).
** - Impact cost calculated for May 2011, Source: NSE Market Tracker, www.nseindia.com.

Investment Objective:
The investment objective of Nifty BeES is to provide investment returns that, before expenses, closely correspond
to the total returns of the securities as represented by the S&P CNX Nifty Index. However, the performance of
Scheme may differ from that of the Underlying Index due to tracking error.

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Relative performance of Nifty BeES:

Note: Trailing Returns up to 1 year are absolute and over 1 year are CAGR. NAV/index values are as on June 27, 2011. Tracking Error is calculated based on daily Rolling Returns for last 12 months.

Relative quarterly performance of Nifty BeES vis--vis S&P CNX Nifty:

60
Nifty BeES Nifty
40

20

-20

-40
Mar-08

Jun-08

Dec-08

Mar-09

Jun-09

Dec-09

Mar-10

Jun-10

Dec-10

Mar-11
Sep-08

Sep-09

Sep-10
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Nifty BeES vs. Nifty Futures:

Comparison of ETFs, Stocks and Mutual Funds:

*= Index funds as well as non Index funds

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Tracking Error:
Investors in an ETF buy or sell a security representing shares in the underlying index fund. They do expect the
price of the ETF to closely track the value of the underlying Index. They also want a sense of how closely the
ETF returns correlate with those of the index. Tracking error helps out the investors to measure whether the ETF
how closely track the underling index.
Tracking error is a statistical term commonly used to describe the volatility of returns of a ETF relative to the
returns of its benchmark index. It is typically expressed in terms of the standard deviation of the differences
between ETF and index returns over a specific horizon. It can be interpreted as the range around the index
return in which ETF returns are expected to be. For example, a tracking error of 1% implies that if the index
return is 10%, the ETF return should be 9%-11% about 68% of the time.
Tracking Error tells how much an ETF's returns deviate from the benchmark index's returns over any given period
of time. An ETF fund manager needs to calculate his tracking error on a daily basis especially if it is open-ended
fund. Lower the tracking error, closer are the returns of the fund to that of the target Index. For investors point
of view, the lower the tracking error, the better is the ETF.
Annualized Tracking Error (TE) calculated for one year period ending:
Junior BeES 0.27

Nifty BeES 0.29

Kotak Nifty ETF 0.29

Quantum Index 0.31

Kotak Sensex ETF 0.33

MoSt Midcap 100 ETF 0.34

ICICI Pru SPIcE Fund 0.42

Bank BeES 0.66

Reliance Banking ETF 0.69

UTI-SUNDER 0.76

0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80

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Advantages of ETFs:
ETFs have some advantages compared to actively managed funds. They are as follows;
Lower expense ratio: ETFs are less expensive schemes than actively and passively managed schemes. The
expense ratio of such funds especially for ETFs is the lowest among mutual fund schemes ranging from 0.35% to
1% (0.75% to 1.5%, in case of index funds and actively managed funds charge up to 2.5% of the corpus) as they
are not necessarily requiring the service of fund managers and analysts. Moreover, there is less marketing cost
and commissions. The average expense ratios for ETF category as on April 30, 2011 was at 0.84% (including gold
ETFs). Hence, Portfolio management of Index funds is much less labor intensive than that of actively managed
funds.
Diversification: The investment through ETFs are widely diversified as indices are constructed to represent
performance of the stock market as a whole. It reduces the overall risk of ones portfolio. Apart from major
indices such as Sensex and Nifty, fund houses have bestowed investors an opportunity to diversify their portfolios
through market capitalization (ICICI Nifty Junior, IDBI Nifty Junior and Junior BeES providing investment
opportunities in mid cap space), focusing on industry (Bank BeES & Infra BeES), asset class (liquid BeES) and
explore in global arena (Hang Seng BeES).
Transparency: Investors can access the portfolio composition of index any day at any point of time. On the
other hand, portfolios of other mutual funds schemes are declared by AMCs once in a month.
No fund manager Risk: As the objective of such schemes is to mimic the performance of index which they track,
they do build portfolio accordingly by investing in the same stocks in the same proportion as the index holds. So
these funds stay away from the risk of subjective performances and biases of fund managers.
Liquidity: As ETFs are listed and traded in stock exchanges like equity shares, they can be bought and sold on
real time basis at currently available prices at any time during trading hours. However, AMCs arrange to absorb
any excess supply of units that an investor would like to sell or create fresh units when the demand for units is
large enough. On the other hand, other funds including index funds that are available only at day-end NAV.

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Disadvantages of ETFs: On the downside, there are some drawbacks associated with ETFs.

Demat account: Demat account and brokers accounts are mandatory for an investor to participate in the ETF
trading as they are traded in stock exchanges. No demat and broker accounts are necessary in case of index and
other mutual funds transactions.
Brokerage Charges: The brokerage charges need to be paid when trading in ETFs. It can be minimized by trading
less but the very charm of ETFs is affected 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 index might be doing very well on the bourses, yet the ETF might be traded at less than the market value of
the index.
SIP in ETF is not convenient as you have to place a fresh order every month and also SIP may prove expensive as
compared to a no-load, low-expense index funds as you have to pay brokerage every time you buy & sell.
True Replication: The index and ETFs may not replicate the returns of underlying index due to management
expenses, cash holding and so on which result in higher tracking error.
Conclusion:

Nifty Bees gives a chance to

1. Participate in the most happening large cap stocks that will ride on growth in Indian economy,
2. Incur low cost in terms of expenses of scheme (compared to a diversified fund) or lower transaction costs
(in the case of direct equity requiring frequent reshuffling),
3. Go in for SIP and take advantage of volatility in the markets to arrive at a lower entry level,
4. Avoid possibility of underperforming the benchmark,
5. Avoid the need of constantly monitoring and reviewing portfolio.

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Analyst: Dhuraivel Gunasekaran. (Database sources: AMC Sites, NAVIndia & Ace MF)

HDFC Securities Limited, I Think Techno Campus, Bulding B, Alpha, Office Floor 8, Near Kanjurmarg Station,
Opp. Crompton Greaves, Kanjurmarg (East), Mumbai 400 042 Phone (022) 30753400 Fax: (022) 30753435
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