UNIT-5 : ETFs, Debt and Liquid Funds

• An ETF (Exchange-Traded Fund) is an investment fund that holds a collection of

assets, like stocks or bonds, and is traded on stock exchanges, just like a regular
stock.
• It allows investors to buy a small portion of a wide range of assets through one
investment, offering diversification at a low cost. For example, a Nifty 50 ETF includes
shares of the 50 largest companies in India, so by buying this ETF, you're investing in
all those companies at once.
• ETFs are generally passively managed, meaning they simply track an index, which
keeps their fees lower compared to actively managed mutual funds. They can be
bought and sold anytime during market hours, providing flexibility and liquidity for
investors.

Assets in ETFs

1) Index ETF: An Index ETF is a type of ETF that tracks a specific stock market index,
such as the Nifty 50 or Sensex in India. An Index ETF is a type of Exchange-Traded
Fund that aims to replicate the performance of a specific stock market index. Rather
than trying to outperform the market, an index ETF invests in the same stocks and in
the same proportions as the index it tracks.
2) Gold ETF: It is a type of Exchange-Traded Fund that tracks the price of gold. Instead
of physically owning gold, such as coins or bars, investors can buy units of a Gold ETF,
which represents ownership in gold holdings. The value of a Gold ETF moves in line
with the price of gold in the market.

Features of ETF

• Diversification: ETFs hold a basket of assets, such as stocks, bonds, or commodities,

which allows investors to diversify their investments without having to buy individual
securities.
• Traded on Exchanges: Like stocks, ETFs are listed and traded on stock exchanges,
meaning they can be bought or sold throughout the trading day at market prices.
• Lower Costs: ETFs generally have lower management fees compared to mutual funds
because most ETFs are passively managed, tracking an index rather than having a
fund manager actively picking stocks.
• Transparency: ETFs typically disclose their holdings regularly, allowing investors to
see exactly what assets the fund holds at any given time.
• Liquidity: Since ETFs are traded on stock exchanges, they offer high liquidity, meaning
investors can buy or sell them easily during market hours.
• Tax Efficiency: ETFs are generally more tax-efficient compared to mutual funds
because of their structure, allowing for fewer capital gains distributions.
 • Flexibility: ETFs allow investors to gain exposure to various sectors, regions, or asset
classes with a single investment, such as index ETFs, sector ETFs, commodity ETFs, or
bond ETFs.
• No Minimum Investment: Investors can buy as little as one share of an ETF, making
them accessible even for small-scale investors.

Debt Mutual Fund Schemes

Debt mutual funds invest in fixed-income securities like bonds and money market
instruments, aiming to provide steady income with lower risk compared to equity funds.
They are suitable for conservative investors seeking stability. The different types are
discussed briefly.

• Fixed Maturity Plans (FMP): FMPs are closed-ended debt funds that invest in fixed-
income securities with a predetermined maturity date. They offer relatively low risk
and predictable returns, and are suitable for investors looking for a fixed investment
horizon.
• Capital Protection Funds: Capital Protection Funds aim to protect the invested
capital by allocating a major portion to safe debt instruments, while the rest is
invested in equities for potential growth. They are designed for conservative
investors seeking safety with some growth potential.
• Gilt Funds: Gilt Funds invest solely in government securities, making them low-risk
investments. These funds are ideal for investors looking for secure fixed-income
assets but may be sensitive to interest rate changes.
• Balanced Funds: Balanced Funds are hybrid funds that invest in both equity and debt
instruments to balance risk and return. They are suitable for moderate-risk investors
seeking a diversified portfolio for both growth and stability.
• Monthly Income Plans (MIPs): MIPs primarily invest in debt instruments with a small
portion in equities, aiming to provide regular income through interest and dividends.
They are ideal for conservative investors looking for steady income with low risk.
• Child Benefit Plans: Child Benefit Plans are designed to help parents save for their
child’s future needs, such as education and marriage. These plans invest in a mix of
equity and debt and are goal-oriented to provide funds at specific milestones in the
child's life.

How is a Debt Instrument Priced?

The pricing of a debt instrument, such as a bond, is based on the present value of its future
cash flows, which include periodic interest payments (coupons) and the repayment of
principal at maturity. The bond price is influenced by the market interest rate, credit risk of
the issuer, and the time left until maturity. When market interest rates rise, the price of
existing bonds tends to fall, and vice versa, because new bonds are issued at the current
interest rate. Additionally, the creditworthiness of the issuer plays a key role: if an issuer is
considered riskier, the bond price typically decreases to compensate for the higher default
risk. The time to maturity also affects bond prices, with longer maturities being more
sensitive to interest rate changes.

Credit Risk

Credit risk refers to the risk that a borrower, whether it’s a company, financial institution, or
even the government, may fail to meet its financial obligations, such as paying interest or
repaying principal on debt instruments like bonds or loans. This risk arises when an issuer is
unable to fulfil its debt commitments, which can lead to financial losses for investors. In
India, credit risk is primarily assessed through credit ratings assigned by agencies like CRISIL,
ICRA, and CARE Ratings. These agencies evaluate the financial health and repayment ability
of issuers, with lower ratings indicating higher credit risk. For instance, government bonds
issued by the Indian government generally carry low credit risk, whereas bonds issued by
lesser-known private companies or corporations might carry higher credit risk, especially if
those companies are not financially stable.

Interest rate risk

It refers to the potential for investment losses due to changes in interest rates. In the Indian
context, this risk is particularly relevant for debt instruments like bonds, fixed deposits, and
debt mutual funds. When interest rates rise, the value of existing bonds or fixed-income
securities tends to fall, and when interest rates fall, the value of these securities typically
rises.For example, if you hold a government bond or a corporate bond with a fixed interest
rate, and interest rates in the market increase, new bonds will be issued at the higher rates.
This makes your bond less attractive because it offers lower returns, causing its price to
drop. On the other hand, if interest rates decrease, your bond becomes more valuable
because it offers higher returns compared to newly issued bonds.

In India, interest rate risk is especially important for investors in long-term debt instruments
or debt mutual funds with long-duration bonds. These securities are more sensitive to
changes in interest rates compared to short-term instruments. For instance, when the
Reserve Bank of India (RBI) changes its policy rates (repo rate or reverse repo rate), it
directly affects interest rates across the economy, influencing bond prices.

Portfolio churning in the context of liquid funds refers to the frequent buying and selling of
securities within the fund's portfolio. This typically involves the fund manager making rapid
changes in the investments to capitalize on short-term opportunities or to adjust the
portfolio's holdings in response to market conditions. In the case of liquid funds, which
primarily invest in short-term debt instruments such as Treasury bills, commercial papers,
and certificates of deposit, churning could occur as the fund manager buys and sells these
instruments to maintain liquidity or adjust to changing interest rates.

Stress testing of assets refers to evaluating how different assets or investment portfolios
would perform under extreme but plausible adverse economic conditions. This process
helps assess the resilience of investments to market shocks, such as economic downturns,
changes in interest rates, or sudden price fluctuations in the asset classes. For example, a
stress test might simulate a severe stock market crash, a sudden rise in interest rates, or a
geopolitical crisis to see how assets like stocks, bonds, or even entire portfolios would react
to these shocks.

CRISIL‘s rating symbols

AAA – This is the highest rating for corporate debentures, meaning they are very safe.
Investors can expect to receive interest regularly, and the chances of the company failing to
repay the principal are extremely low.

BBB – These debentures are still considered safe, but there is a small risk. If the economic
environment changes, the company might face difficulty in paying interest or repaying the
principal.

Market making by APs (Authorized Participants) refers to the role played by specific
financial institutions or entities that help create a liquid market for Exchange-Traded Funds
(ETFs). They do this by being ready to buy or sell ETF shares at any time. In simple words,
Authorized Participants (APs) are responsible for ensuring that ETFs have enough buyers and
sellers. They do this by creating new ETF shares or redeeming existing ones to match supply
and demand. This helps keep the price of the ETF close to its true value, based on the
underlying assets, and makes it easier for investors to trade ETFs without big price
fluctuations.

Nature of Debt Funds

Debt funds are investment vehicles that primarily invest in fixed-income securities such as
bonds, government securities, and money market instruments. The primary objective of
debt funds is to provide investors with regular income through interest payments, along with
capital preservation. These funds are considered safer than equity funds because they are
less volatile and are largely influenced by interest rates and credit risk rather than market
fluctuations. Debt funds can range from short-term funds, which invest in instruments with a
shorter maturity, to long-term funds that hold bonds with a longer duration. They are ideal
for conservative investors seeking stable returns with lower risk.

Floating Rate Scheme

A Floating Rate Scheme is a type of debt mutual fund that invests in debt instruments with
variable interest rates, which adjust according to changes in benchmark rates like the repo
rate. These schemes are less affected by interest rate changes compared to fixed-rate funds,
as rising rates can increase returns. They are suitable for investors looking for protection
against rising interest rates while maintaining lower risk.

Liquid Mutual Funds

Liquid mutual funds are a type of debt mutual fund that invests in short-term money market
instruments, such as Treasury bills, certificates of deposit, and commercial papers. These
funds aim to provide safety, liquidity, and modest returns, making them ideal for investors
who want to park their money for a short period, typically a few days to a few months.
Liquid funds are considered low-risk because they primarily invest in highly liquid and stable
instruments with very short maturities.

Yield to Maturity (YTM)

Yield to Maturity (YTM) is the total expected return an investor can earn if a bond is held
until its maturity date. It considers the bond's current market price, its face value, the
coupon interest payments, and the time remaining until maturity. YTM is expressed as an
annual percentage rate and reflects the annual return an investor would receive based on
these factors.