Exchange Traded Funds as a successful way of disinvestment

One of the components of the Union Budget of 2017 has been the proposal to launch more CPSE ETFs in the coming financial year. This proposal has been adopted seeing the overwhelming response that the government has received for this scheme in the past two years.  A special type of mutual fund, Central Public Sector Enterprise Exchange Traded Funds (CPSE ETFs), was launched by the Government on 18^th March 2014 to disinvest in the public sector firms. The notion behind this launch was that it would be a tool for the government to disinvest depending on market situations. The CPSE ETFs comprises of 10 companies – Oil and Natural Gas Corp. Ltd, GAIL (India) Ltd, Coal India Ltd, Rural Electrification Corp. Ltd, Oil India Ltd, Indian Oil Corp. Ltd, Power Finance Corp. Ltd, Container Corp. of India Ltd, Bharat Electronics Ltd and Engineers India Ltd. In order to analyze the role of these Exchange Traded Funds as a successful way of disinvestment of the Central Public Sector Enterprises, one needs to understand the concept, working, advantages and disadvantages of the whole scheme of investment.

What are ETFs?

ETFs are a kind of Collective Investment Schemes (CIS). Collective Investment Schemes which are also regulated by Section 11AA of the SEBI Act, are nothing but a mechanism by which several investors pool in their money to invest in a particular asset. Then they share the returns from these investments in a previously agreed upon proportion.

Now coming back to ETFs, they are a kind of marketable security can be tracked on indexes, commodities, bonds etc. They undergo fluctuations in prices as they are bought and sold throughout the day. When a person is buying an ETF, he/she is basically buying shares of a portfolio that tracks the yield and return of its native index. The main difference noted between the ETFs and other types of index funds is that ETFs don’t try to outperform their corresponding index but instead try to replicate its performance.

Differences between ETFs and Mutual Funds

Although the ETFs are quite similar to Mutual Funds in their style, there are some glaring differences which one should note. These are:

• Place of trade– Mutual Funds are not traded on the stock exchange and are to be bought directly from the respective fund houses. But ETFs are traded on the exchange and can be bought and sold on the exchange.
• Share trading accounts– Share trading accounts are not necessary to buy MFs. But since ETFs are traded on the market it is necessary to have a trading account to trade in ETFs.
• Pricing– While the price of the ETFs keep fluctuating throughout the day at the time of their buying and selling, mutual funds are priced only once in a day at the time of closing of the market.

There is a current trend to shift from the Mutual Funds to ETFs considering them a more viable option for investment than mutual funds.

How does an ETF work?

Under an Exchange Traded Fund, certain assets are owned like shares of stock, bonds, foreign currency etc. These assets are then divided into shares. These shares are made available through a Collective Investment Scheme for the public to purchase. Thus, the shareholders indirectly own the assets for which they bought the shares. The shareholders also get some returns in terms of dividends or interests.

Certain assets for which investment in ETF can be made are:

• Equities: e.g. CNX Nifty, CNX Junior Nifty
• Commodities: e.g. Gold ETF
• Money market instruments: short term government securities and call money.

How can ETFs play a significant role in disinvestment of Central Public Sector Enterprises?

The CPSEs can increase the pace of disinvestment only when more people invest in the ETFs. The data indicates that indeed a major group of investors in India have invested in ETFs due to certain advantages that they had in this investment. These advantages include:

• Investment in low cost– The first investors in these ETFs were given a discount of 5% on the market price of these shares. There was a grant of a ‘loyalty bonus’ of 1/15 for the investors who held the shares for atleast a whole year.
• The FFO– The government’s previous offer attracted a lot of response. So, it is planning to extend the same to the next round of ETFs terming it as a ‘Further Fund Offer (FFO). Thus, the investors shall receive the same benefit as initial investors.
• Huge returns– The current investors have witnessed an increase in their returns at 12.21% per annum, in addition to the bonus that earned them an additional 6.66%. This was mainly due to the offers given by the government. If these offers continue, it will definitely earn the same returns in the coming future.
• Intra-day purchase and sell-The best part about ETFs is that they can be purchased or sold at any time of the day at the prevailing price. This gives flexibility to the investors to sell their ETFs at the time of price rise and buy at the time of low prices.
• Additional costs– One of the benefits of ETFs being traded in stock exchanges is that the costs of distribution of these are pretty low. So it even becomes feasible for the CPSEs to issue and redeem these without much cost being incurred.
• Less cash transaction-This is particularly important at times of demonetization as the subscription or redemption of these ETFs occur through exchange with underlying securities than with hard cash. However, this is applicable to only large deals.
• Transparency-There is also a lot of transparency in the process as the investor gets to track the market of these securities throughout the day.
• Exposure– Due to the above benefits, the ETFs also provide a good opportunity to investors to get an exposure to the equity market at a very affordable cost, both for the purpose of exquisite and arbitrage.
• Benefit for government-This has become one of the easiest mechanisms for the Public Sector Enterprises to disinvest. They are getting a constant rollout of investors throughout the day who are trading in ETFs. This makes the process faster on a daily basis. The government is not required to wait for the end day valuations and purchases unlike the other securities and bonds of government.
• High Net Worth and Retail investors– The recent proposals indicate that the government aims to bring these two categories of investors into holding shares in PSEs. It will increase their exposure to the market.

What are the risks associated with ETFs?

While answering the question as to how ETFs are useful in disinvestment process, one cannot ignore the risks that an investor faces in this market which can deter him or her to trade in these securities. These are as follows:

• Market conditions not being favorable– It is possible that the market of these securities may not always be favourable. So the investors should not buy these thinking of all-time good returns from them.
• Absence of retail investors from the entire process-This has been a problem till date, as less of retail investors have shown interest. But the government aims to do away with this through FFOs.
• Very rigid bureaucratic processes-In the CPSEs we find dominance of oil companies. It has also been cited by many critics that one should not be completely dependent on the current returns as PSEs are generally known for the low returns that they yield.

Conclusion

In spite of some of the risks involved in the process, the investment in ETFs appears to be very lucrative. An individual or organization wanting to try the securities market can easily take up this small risk. It will give them an exposure to a PSE also and will in turn help them be a part of the long term development of the economy.