Exchange Traded Fund

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Context

• SEBI, the markets regulator, has issued directives to mutual fund houses, instructing them to cease accepting further inflows into schemes investing in overseas exchange-traded funds (ETFs) from April 1, 2024.
• This action comes in response to the near-fulfillment of the mandated investment limit of $1 billion in foreign ETFs.

What is an Exchange Traded Fund?

• An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.
• Unlike regular mutual funds, an ETF trades like a common stock on a stock exchange. The traded price of an ETF changes throughout the day like any other stock, as it is bought and sold on the stock exchange.
• The trading value of an ETF is based on the net asset value of the underlying stocks that an ETF represents.
• ETFs typically have higher daily liquidity and lower fees than mutual fund schemes, making them an attractive alternative for individual investors. ETFs are considered to be more tax efficient compared to other mutual fund schemes.
• There are mainly five types of ETFs – equity ETF, bonds ETF, commodity ETF, international ETF and sectoral/thematic ETF.

Reasoning Behind SEBI's Direction

• The capital market regulator's move aims to prevent breaching the upper limit of $1 billion for investments in overseas ETFs.
• According to industry insiders, the mutual fund sector has already reached 95% ($950 million) of the $1 billion limit, prompting SEBI's intervention to temporarily halt inflows into overseas ETFs.

Overall Limit for Mutual Funds Investing in Overseas ETFs

• Currently, the Reserve Bank of India (RBI) has set an overall cap of $7 billion for fund houses to invest in overseas stocks or mutual funds.
• Mutual funds are permitted to invest up to $1 billion in overseas exchange-traded funds.
• The mutual fund industry has been advocating for an increase in the overseas investment limit beyond the existing $7 billion.

RBI's Response to the Industry's Demand

• RBI has acknowledged the mutual fund industry's requests to revise the overseas investment limit.
• However, RBI emphasized that any decision on revisiting the limit would be contingent upon the stability of the rupee on a durable basis.

Understanding Exchange Traded Funds (ETFs)

Definition and Characteristics

• An ETF, or exchange-traded fund, is a marketable security that tracks an index, commodity, bonds, or a basket of assets, similar to an index fund.
• Unlike traditional mutual funds, ETFs trade on stock exchanges like common stocks, with their prices fluctuating throughout the trading day based on supply and demand.
• ETFs offer higher daily liquidity and lower fees compared to mutual fund schemes, making them an appealing option for individual investors.
• They are considered more tax-efficient and offer diverse investment options, including equity ETFs, bonds ETFs, commodity ETFs, international ETFs, and sectoral/thematic ETFs.

PRELIMS QUESTION Q.  Explain the concept of Exchange Traded Funds (ETFs) and their relevance in the Indian financial market.