They allow you to participate in the government bond market at a low cost, but liquidity can be a problem.

                                      

In India, you can buy exchange traded funds (ETFs) with stocks or gold as underlying instruments, but options are limited if you are looking for passive exposure to fixed income securities. LIC Nomura MF and Goldman Sachs MF have offerings in the form of LIC Nomura G-sec Long Term ETF and Goldman Sachs Liquid Exchange Traded Scheme. Now, Reliance Mutual Fund and SBI Mutual Fund have filed offer documents with Sebi for gilt ETFs. How do these products fare vis-a-vis existing gilt-based bond funds? Can they add value to your fixed income portfolio?

PLAYING ON INTEREST RATES

An ETF is a passively managed fund which typically holds securities in the same proportion as the index it tracks. Unlike actively traded funds, these merely seek to replicate the performance of the underlying index and do not bet on outperformance of particular stocks or holdings. The proposed two ETF offerings will track the benchmark 10year government bond as the underlying index. While actively-managed gilt funds play on duration to maximise alpha over the benchmark, these gilt ETFs will merely replicate the movement of the underlying index. While Reliance MF's R* Shares Long-Term Gilt ETF will be benchmarked against GSEC10 NSE, SBI MF's SBI-ETF 10year Gilt will mimic CRISIL 10-year Gilt Index. Reliance MF's offering is meant for institutional investors and HNIs with a minimum ticket size of `5 lakh, whereas SBI MF's offering is for retail investors with a minimum investment of `5,000.

But why invest in government bonds in the first place? Investing in gilts gives you the chance to benefit from movements in domestic interest rates. Especially when interest rates are declining, like now.When interest rates fall, bond prices rise, pushing up the value of the funds holding these bonds. Bonds with longer duration benefit the most, as they are the most sensitive to interest rate movement. Effectively, investing in the 10-year government bond offers investors a direct play on the interest rate cycle.However, this is already offered by several actively managed bond funds sold by mutual fund companies. Why would one want to take the ETF route to get the same exposure offered by these funds? The clear benefit offered by these giltETFs is the lower expense ratio.While actively managed bond funds can charge up to 2.25%, SBI'S Gilt ETFs will cost only up to 1.5%.However, there are many actively managed gilt funds charging much lower than 1.5%.

POTENTIAL PITFALLS

There are issues to keep in mind.First, the success of the ETFs will depend a lot on whether they are able to offer enough liquidity. Unfortunately, ETF products in the country suffer from acute liquidity pangs. The trading volumes on these are at times so low that investors are unable to buy or sell at the desired price at the desired time.The trading price often deviates significantly from the actual NAV of the fund. In some cases, days go by without even a single unit being traded on the exchange. This can be harmful for the investor since timing entry and exit is critical while playing on interest rate movements. Being a passively managed product, the onus of timing would lie squarely on the investor's shoulders. You have to get in when bond yields are expected to come down and then get out before yields rise again.

In the case of gilt ETFs, the discretion of choosing the duration is passed on to the investor. In an actively managed gilt fund, the element of market timing is mitigated to some extent. The professional fund manager will shift between government securities of different maturities in response to changes in interest rates and will be able to soften the blow of any adverse market movements. The ETF investor, on the other hand, would be stuck holding the same paper. Investors in many ETF products face the prospect of having no counterparty at the time of buying or selling their holdings.

Besides, tracking error--difference between the return of the fund and that by its underlying index--can be higher for bond ETFs. Given the illiquid nature, the replication of underlying index is much more difficult for a bond ETF compared to an equity based ETF. The tracking error would be higher in this case.

Apart from this, the fund will have to bear the cost of switching to a new paper whenever the central bank issues a fresh 10-year bond. The ETF will be forced to sell an existing 10 year bond and buy the newly issued bond. Apart from the transaction cost, investors may also be hit by impact cost resulting from possible lack of liquidity in the papers.

SHOULD YOU BUY?

Experts reckon this is a good option for investors who are nuanced enough to take views on interest rates. It allows investors who have a clear view on interest rates to participate at a low cost Cautions that gilt funds are not for everyone. Opt for them only if you have the risk appetite and wish to play the interest rate cycle on your own. However, investors would do well not to pounce on these ETFs when they are launched; wait to check if they are able to generate enough volumes on the bourses. You would not want to get stuck in an illiquid instrument that could prevent you from timing your exit at a profit.