Investment tips for Exchange Traded Funds​​​

Exchange Traded Funds - A resourceful product to invest in asset classes 

 

Mutual Funds provide an important and convenient way of financial planning for retail investors due to various factors such as economies of scale and low costs. In addition, Mutual Funds also provide investors with an opportunity to invest across asset classes, sectors and geographies via various schemes. Further, investors can diversify their portfolios by following different investment styles of wealth or fund management, viz., the active style or the passive style. Those funds which

consistently churn their portfolio and aim to outperform the market or a benchmark index are called actively managed funds. In contrast, those funds which aim to generate returns in line with a benchmark index by replicating its portfolio are referred to as passively managed funds.

    

Exchange Traded Funds (ETFs)

Passively managed funds are best represented through ETFs. These funds invest into an underlying asset or portfolio of assets and trade over stock exchanges. The underlying portfolio may represent an index, securities or commodities. ETFs can be easily bought / sold anytime during market hours like any other stock on the exchange. The trading price is usually close to the fund’s actual net asset value (NAV). Investments in ETFs, however, require investors to hold share trading and demat accounts. 

    

Investing in ETFs

ETFs can be bought or sold in two ways. But before you begin to invest in ETFs, it is important that you take into account the following points: 

1. You need to open a trading account with a broker/ sub-broker.

2. You should also have a demat account for holding the ETF units.

  

To complete these formalities, you have to be KYC compliant and required to furnish documents like:

A. Proof of identity: Passport, Driving License, PAN Card

B. Proof of Address: Passport, Utility Bill

C. Bank Account Details: Bank Account Statement

After you complete these formalities, you can buy and sell ETFs through this account.

    

You can invest in ETFs by:

A. Buying or selling ETF units through the broker by telephonic mode or by placing orders on the online trading terminal provided by the broker. You should also check whether the broker is registered with the stock exchange. 

B. You can place your order by calling your broker and informing him about your trade specifications. 

C. You can also place your order through online trading terminal. Trading ETFs is similar to buying and selling shares on exchanges through the terminal. Benefits of investing in ETFs:

  

Diversification: ETFs offer you exposure to a wide range of securities like an index and are traded like a stock. ETFs help you spread investment risk over a number of securities and reduce stock-specific risk. Investment in ETFs can be looked at as a part of hedging strategy. Depending upon the ETF scheme, you can gain exposure to a range of stocks, countries. Sectors, commodities etc in a single transaction.

  

Transparency: Most of the ETFs track an index and this would mean passive management for the fund house to maintain the ETF portfolio. This makes it easier for the investor to know performance of the ETF.

  

Portfolio Management: ETFs help fund managers with constant inflow and out flow of funds. ETFs are liquid investment products that fund managers can easily buy or sell on exchange. This help in effective portfolio management for the fund managers. 

Convenience: You can buy and sell ETF shares on exchanges by looking at the market prices available on the trading portal. ETFs are listed on exchanges that are well regulated. This has contributed to transparency in trading ETFs. Also, investors who are unsure of which investment product to choose can invest in Index ETFs, which will provide them exposure to the market.

  

Lower Transaction Charges: ETFs can be traded at much lower cost that what you would incur on other index tracking products. Investors who are unsure of which stock to invest in can invest in a sector-based ETF and benefit from the sectoral growth by investing a small amount of capital.

  

Tax Benefits: Dividends from ETF schemes are tax exempt for investors. If an investor sells ETFs units before 12 months, he is liable to pay short term capital gain tax at the rate of 10 percent. At the time of redemption the investor need not pay tax. They are also exempt from wealth tax. However, the time of redemption investors would need to pay securities transaction tax (STT) at 0.25 percent on the value of redemption.

  

Arbitrage Opportunities: ETFs, being index tracking products, can be used to generate profits out of price differences between ETFs and other index products like futures etc. 

  

Conclusion 

Though Indian ETFs are still at an emerging stage, they are expected to replicate some of the asset classes that are offered globally, with gold ETFs the likely leader. Recent launches, which include differentiated products such as MOSt Shares NASDAQ 100, Goldman Sachs Hang Seng BeES, Goldman Sachs S&P Shariah BeES, give investors diverse but attractive choices across asset classes, investment styles and geographies. While actively managed funds will continue to rule in search of higher alpha, passively managed funds in the form of ETFs can be of able help to investors for quick diversification across underlying asset class / index.

  

        

Understanding Interest Rates, Inflation And Bonds

Understanding Interest Rates, Inflation And Bonds 

Ownership of a bond is the ownership of a stream of future cash payments. Those cash payments are usually made in the form of periodic interest payments and the return of principal when the bond matures. In the absence of credit risk (the risk of default), the value of that stream of future cash payments is simply a function of your required return based on your inflation expectations. If that sounds a little confusing and technical, don't worry, this article will break down bond pricing, define the term "bond yield" and demonstrate how inflation expectations and interest rates determine the value of a bond

There are two primary risks that must be assessed when investing in bonds: interest rate risk and credit risk. Though our focus is on how interest rates affect bond pricing, otherwise known as interest rate risk, it's also important that a bond investor be aware of credit risk. Interest rate risk is the risk of changes in a bond's price due to changes in prevailing interest rates. Changes in short-term versus long-term interest rates can affect various bonds in different ways, which we'll soon discuss. Credit risk, meanwhile, is the risk that the issuer of a bond will not make scheduled interest and/or principal payments. The probability of a negative credit event or default affects a bond's price - the higher the risk of a negative credit event occurring, the higher the interest rate investors will demand for assuming that risk.

Calculation of a Bond's Yield and Price

To understand how interest rates affect a bond's price, you must understand the concept of yield. While there are several different types of yield calculations, for the purposes of this article, we will use the yield-to-maturity (YTM) calculation. A bond's YTM is simply the discount rate that can be used to make the present value of all of a bond's cash flows equal to its price. In other words, a bond's price is the sum of the present value of each cash flow where the present value of each cash flow is calculated using the same discount factor. This discount factor is the yield. When a bond's yield rises, by definition, its price falls, and when a bond's yield falls, by definition, its price increases.

A Bond's Relative Yield

The maturity or term of a bond largely affects its yield. To understand this statement, you must understand what is known as the yield curve. The yield curve represents the YTM of a class of bonds (in this case, U.S. Treasury bonds). In most interest rate environments, the longer the term to maturity, the higher the yield will be. This should make intuitive sense because the longer the period of time before a cash flow is received, the more chance there is that the required discount rate (or yield) will move higher.

Inflation Expectations Determine Investors Yield Requirements

Inflation is a bond's worst enemy. Inflation erodes the purchasing power of a bond's future cash flows. Put simply, the higher the current rate of inflation and the higher the (expected) future rates of inflation, the higher the yields will rise across the yield curve, as investors will demand this higher yield to compensate for inflation risk.

Short-Term, Long-Term Interest Rates and Inflation Expectations

Inflation - and expectations of future inflation - are a function of the dynamics between short-term and long-term interest rates. Worldwide, short-term interest rates are administered by nations' central banks. In the United States, the Federal Reserve Board's Open Market Committee (FOMC) sets the federal funds rate. Historically, other dollar-denominated short-term interest, such as LIBOR, has been highly correlated with the fed funds rate. The FOMC administers the fed funds rate to fulfill its dual mandate of promoting economic growth while maintaining price stability. This is not an easy task for the FOMC; there is always much debate about the appropriate fed funds level, and the market forms its own opinions on how well the FOMC is doing.

Central banks do not control long-term interest rates. Market forces (supply and demand) determine equilibrium pricing for long-term bonds, which set long-term interest rates. If the bond market believes that the FOMC has set the fed funds rate too low, expectations of future inflation increase, which means long-term interest rates increase relative to short-term interest rates - the yield curve steepens. If the market believes that the FOMC has set the fed funds rate too high, the opposite happens and long-term interest rates decrease relative to short-term interest rates - the yield curve flattens.

The Timing of a Bond's Cash Flows and Interest Rates

The timing of a bond's cash flows is important. This includes the bond's term to maturity. If market participants believe that there is higher inflation on the horizon, interest rates and bond yields will rise (and prices will decrease) to compensate for the loss of the purchasing power of future cash flows. Those bonds with the longest cash flows will see their yields rise and prices fall the most. This should be intuitive if you think about a present value calculation - when you change the discount rate used on a stream of future cash flows, the longer until a cash flow is received, the more its present value is affected. The bond market has a measure of price change relative to interest rate changes; this important bond metric is known as duration

The Bottom Line

Interest rates, bond yields (prices) and inflation expectations have a correlation to one another. Movements in short-term interest rates, as dictated by a nation's central bank, will affect different bonds with different terms to maturity differently, depending on the market's expectations of future levels of inflation.
For example, a change in short-term interest rates that does not affect long-term interest rates will have little effect on a long-term bond's price and yield. However, a change (or no change when the market perceives that one is needed) in short-term interest rates that affects long-term interest rates can greatly affect a long-term bond's price and yield. Put simply, changes in short-term interest rates have more of an effect on short-term bonds than long-term bonds, and changes in long-term interest rates have an effect on long-term bonds, but not short-term bonds.
The key to understanding how a change in interest rates will affect a certain bond's price and yield is to recognize where on the yield curve that bond lies (the short end or the long end), and to understand the dynamics between short- and long-term interest rates. With this knowledge, you can use different measures of duration and convexity to become a seasoned bond market investor.

Tactical Tips For Bond Investors

Fixed-income markets are an extremely dynamic and fascinating aspect of our investment universe, not to mention one of the more predictable ways to tactically profit from long-term market trends. The interest rates among various bonds are constantly in a state of flux, providing numerous opportunities for astute investors. Having the necessary knowledge to recognize a good deal when you see it is key to successful, opportunistic investing in fixed-income markets. As such, this article will examine the key components of interest rates, what factors affect them and how to apply this knowledge to make tactical fixed-income investments.

Basic Components of Interest Rates

The basics components for bond interest rates are simple and can be calculated with a very small amount of research. Essentially, all you need to do is compare the rates of U.S. Treasury Inflation Protected Securities (TIPS), U.S. Treasury bonds and non-government bonds.

1. Real Risk-Free Rate - This is a base rate of return for any given period and can be found by looking at yields for U.S. TIPS, which are inflation protected. Therefore, their yields are based on real returns.
2. Expected Inflation - This is the second component of interest rates and can be easily found by subtracting the yield of a TIP from a normal (or nominal) U.S. Treasury bond. The result of this calculation is what the market expects the annualized inflation to be over any given time period.
3. Credit Risk Premium - This is the final component of interest rates and is the premium that investors require to take credit risk, or the chance that they won't be repaid. This premium only applies to bonds that are not backed by the U.S. government and can be found by subtracting the yield of a U.S. Treasury bond from a U.S. corporate or mortgage-backed bond. Keep in mind that credit premiums vary widely depending on the credit quality of the issuer and the instrument in question. The example below is purely for illustrative purposes.

Where to Focus Your Efforts

In order to maximize your chances of success in fixed-income investing, it is best to decide where to focus your tactical efforts; risk-free rates, expected inflation or credit premiums. Keep in mind that although risk-free rates do vary quite a bit over time, such changes are very difficult to predict. Therefore, it's not likely a good use of effort to engage in market timing activities with respect to real interest rates.

Another area in which you can focus your efforts is being tactical with respect to expected rates of inflation. For example, if you believe expected rates of inflation will fall, you would buy nominal bonds and reap the rewards of a decrease in total interest rates as those expectations fell. As with risk-free rates, market timing the changes in inflationary expectations is extremely difficult. Moreover, the absolute amounts of the changes in real interest rates and inflation are typically modest in nature, leaving small rewards even if you are correct (assuming no leverage is involved).

Where you really want to focus your attention, however, is on credit risk premiums, which are substantially more volatile than the aforementioned factors. This is because fluctuations in credit premiums are generally tied to economic cycles. Moreover, the absolute numbers involved in credit premiums are much larger than those associated with real interest rates or inflationary expectations. From a tactical standpoint, this is where you should focus your efforts. Therefore, you need to understand what factors affect credit risk.

Credit Risk Basics

From a big-picture standpoint, credit risk premiums are very simple to understand. Keep in mind that credit risk can take a lot of forms. It could be corporate debt of all kinds as well as mortgage-backed debt. Each type of credit risk has an associated risk premium. For example, AAA-rated corporate bonds will have a lower credit risk premium than say, a junk bond; the same applies to mortgage-backed bonds of varying quality.

What is important to understand is that credit risk premiums fluctuate along with the economy. This means that if the economy is strong, companies are more likely to make their debt payments and the market correspondingly assigns a lower credit risk premium during such times. Conversely, if the economy enters a recession, corporations (and other debtors) are less likely to make their payments. As a result, the market assigns a higher credit risk premium during these times. As such, the cycle of risk premiums closely tracks the health of the broad economy, or at least the area of the market in which the debtor operates (mortgages, corporations, municipalities, etc.).

Profiting Tactically

How can an investor profit from these cycles? It's relatively simple for those who can employ the appropriate level of patience and avoid the herd mentality. This is because it is the herd mentality that creates opportunity. Profits are made by avoiding credit risk when the compensation is poor (i.e. low premiums) during times of strong economic activity. You want to avoid investing during these times because economic cycles are inevitable, and you will surely see an economic downturn, which will lead to higher credit premiums (or higher interest rates). This leads to losses - as rates go up, bond prices go down. Treasury bonds make a fine investment at the peaks of economic cycles, because the foregone credit premium is very low, and when things turn sour, these bonds tend to perform very well.

The Bottom Line - Proceed with Patience and Caution

Tactical fixed-income investing is not only possible, but potentially profitable as well. However, don't get too excited and start trading bonds just yet. Keep in mind that these sorts of tactical opportunities do not always present themselves on a daily, monthly or even annual, basis. Furthermore, successfully profiting in the manner described above is a function of patience and the willingness to move against the herd by avoiding credit risk when it's popular and embracing it when it's not

Finally, investors should always take a long-term approach toward fixed-income investing. It could take years for a tactical strategy to come to fruition, which could leave impatient investors wishing they were in another asset class altogether.