In chapter 7, we examined mutual funds and their mechanism. This investment vehicle pools the cash of various investors and then manages those funds on their behalf. Investing prior to the cut off point yields units based on that day’s NAV – revealed at midnight. Once the deadline passes though, allotments are furnished using the following days’ NAV. Ultimately, everything wraps up daily.
Imagine if mutual fund units were able to be bought and sold on the stock exchange, just as stocks like Reliance or Infosys are? Exchange-traded funds (ETFs) work in a similar fashion, with them being collective investments which contain a combination of stocks, bonds and commodities, and also being tradeable on stock exchanges. They provide the same advantages as mutual funds but with the ability to buy or sell at any moment.
Before going into greater detail, let me make sure you have a basic understanding of the concept of ETFs.
Mutual funds have been around since the early 1900s, with the US’ first open-ended fund debuting in 1924. 1964 saw India’s inaugural offering. These vehicles have enabled average investors to access stocks, bonds, real estate and commodities worldwide. Building on this idea of democratised investing were exchange-traded funds (ETFs).
ETFs are a relatively recent innovation. The SPDR S&P 500 trust, thought to be the first of these, was launched in 1993 in the US and is now among the most traded securities in the world. In India, NiftyBeES – tracking the Nifty 50 index – was introduced by Benchmark AMC in 2002. This fund has gone through several ownerships since then, being passed from Goldman Sachs to Reliance and eventually to Nippon India Mutual Fund.
Exchange traded funds (ETFs) have existed in India for some time, yet they haven’t been embraced by retail investors as much. The wealthiest individuals and organisations are primarily the ones who have invested in them – the SBI Nifty 50 ETF, a prime example, is the biggest mutual fund with 89,441.55 crores. This could be attributed to EPFO’s decision to put money into this particular ETF.
A large part of the ETF AUM growth is due to:
Retail involvement has increased considerably over the years, resulting in a rise in trading activity on exchanges. Although they remain but a small part of the whole picture, this growth is encouraging.
NiftyBeES which is 20 years old, just has about Rs 2800 crores of AUM. There are a lot of reasons for the under penetration of ETFs:
An exchange-traded fund (ETF) does not share the same qualities as a mutual fund. While both types of funds are composed of multiple securities, ETFs differ in that they can be traded on the stock exchanges like a regular stock during market hours. This allows for investors to purchase and sell these funds at any desired time.
For example, if you search for “Nifty ETF” on Kite, you’ll see a list of all ETFs that track the Nifty 50 index.
When investing in a mutual fund, the Asset Management Company (AMC) collects payment from you to obtain the offered securities and reveals the Net Asset Value (NAV) at the close of the day. Likewise, upon redemption of mutual funds, the AMC disposes off those securities and refunds your money. This system is quite simple. On the other hand, exchange-traded funds are usually bought and sold on stock exchanges thus you hardly ever have contact with an AMC. It’s just trading between investors in terms of units.
When you invest in an ETF, you typically won’t need to directly interact with the AMC. To gain an understanding of what this involves, take a look at chapter 6 which discusses all aspects of an MF transaction such as the AMC, custodian and RTA. However, there is something unique about ETFs – the creation and redemption mechanism. Before delving into that further, let’s learn a few things first.
When you invest in a mutual fund, you need to consider its NAV. Likewise, when investing in an ETF, it is important to take note of the ETF market price available on Kite.
The demand, supply and trading activity on the exchanges all contribute to the price of an ETF. But how can you tell if you’re paying a fair price for it on Kite? That’s where the Net Asset Value (NAV) comes in.
An ETF, like a mutual fund, has an end of day Net Asset Value (NAV). This is used to help you determine the total value of your shares and all the fund’s assets. The formula for NAV is (Value of all the assets – expenses)/number of shares (units). An ETF can trade in real-time, however NAVs are only released at the close of day. To understand if the current price of an ETF is reasonable in real-time, its iNAV can offer assistance.
An iNAV serves as a reference point, so you know that the market price you’re seeing on your trading platform is fair. Asset Management Companies (AMCs) often calculate this every 10-15 seconds and make it available on their websites. It’s an equation of the last traded price of all securities in the ETF basket multiplied by the number of shares in the ETF creation basket, plus cash not allocated to the ETF, all divided by the total ETF shares in the creation basket. In other words, an iNAV takes into account real-time factors to provide a benchmark for comparing to current exchange prices.
Investing in ETF units can be done either on the exchange or directly through the AMC. Later, I will explain why you may choose this option. Unlike when purchasing from the stock exchange, it is not possible to buy one or two units directly from the AMC. All transactions must be made in what is called a ‘creation size’, which is defined by the AMC. A creation unit is a basket of securities that mirror their underlying index on a proportionate basis. For example, the ICICI Nifty 50 ETF has a creation unit size of 50,000 and as of today amounts to around 80 lakhs – this means that 80 lakhs are needed to purchase all stocks included in the Nifty 50 at their appropriate weightings.
Market makers or authorised participants play an essential role in the ETF ecosystem as they ensure liquidity on the stock exchanges. Unlike mutual funds, which do not require such services due to their absence of real-time trading, market makers are appointed by asset management companies (AMCs) and offer continuous two-way quotes on the exchange; buying at the bid and selling at the offer. Although the profits made from these activities are small, they eventually add up significantly over time.
Market makers typically tend to be large brokers in India.
ETFs trade on the exchanges in real-time, meaning their price is determined by demand and supply. Generally, prices of liquidity ETFs match their NAV in stable market conditions. However, in more turbulent times, the ETF’s value may not accurately reflect its NAV; If the price of an ETF is more than its NAV it is referred to as a premium and conversely if it’s lower than its NAV it is classified as a discount.
Tracking error is the standard deviation of the yearly difference between an ETF’s NAV returns and its underlying index. In other words, it tells you how well an ETF replicates its benchmark. For instance, if the Nifty 50 had a return of 10% and the corresponding ETF gave 9.8%, then tracking error would be 0.2%. An ETF or an index fund typically has slightly lower returns compared to its reference index since they incur expenses while an index doesn’t.
An ETF or an index fund’s tracking error can give us an idea of how well it is replicating the index. We’ll go into further detail about this later.
It’s important to understand the creation and redemption mechanism. You don’t have to always get an ETF from the stock exchange; if you buy in multiples of the creation unit size, it’s best to purchase it directly from the Asset Management Company (AMC). That way, you avoid liquidity issues and potentially high trading costs that can come with buying large amounts on an exchange.
The example being discussed is the ICICI Nifty 50 ETF, which has a creation size of roughly 80 lakhs. If you decide to commit to this amount in multiples, you can directly get in contact with ICICI who will then create 50,000 units and credit them to your demat. The AMC will generate these units at their set iNAV. To redeem them, assets can be transferred from your ETF units to ICICI who will then deposit the funds into your bank account, or if preferred, you will be able to receive the underlying shares instead of cash.
The second importance of the creation and redemption mechanism is to facilitate ETF arbitrage. As mentioned before, ETFs can sometimes trade at premiums or discounts to the NAV. This is where market makers come in; they help to rectify these premiums and discounts by taking advantage of the creation and redemption process.
Comparing ETFs such as Nifty BeES, SBI Nifty ETF, ICICI ETF and Nifty 50, we find that they usually trade close to their NAVs.
During the COVID crash in 2020, popular ETFs like NiftyBeEs and SBI Nifty 50 ETF, India’s largest mutual fund, demonstrated wide premiums and discounts. Let’s take a look at how these ETFs performed during the market volatility in March-April 2020.
Market makers step in here with the premium. An authorised participant (AP) will purchase all 50 stocks of the Nifty at the same weight, which is known as the creation basket. The AP hands this over to the asset management company (AMC), who then produces ETF shares for them. These are then given back to AP for selling on the stock exchange.
The AP will purchase ETF units from the exchange if there are any discounts available and hand them over to the AMC. In exchange, the AMC will provide the underlying shares of the ETF to the AP, who can then sell them in the market. The gap between bargain, discount and NAV will equal to gain for the AP/market maker.
The Motilal Oswal NASDAQ 100 (N100) may be the clearest indication of this phenomenon, with premiums as high as 20%+ during 2017-2018, likely due to limited market maker activity. Have a look at the price and NAV comparison provided by Value Research; there is a striking difference between them.
One could have capitalised on this advantage by visiting Motilal AMC and requesting that they create units, to be purchased at the NAV price and then sold at the current market price on the exchange. The end result would have been a lucrative profit.
The premium held firm for quite a while. If I recall correctly, Motilal then appointed new market makers and created a fund of fund (FOF) for the ETF which helped correct the premium. By 2018, this would have meant that the market makers were producing Motilal units at their NAV and selling them on the exchange at their market price which in turn, corrected the premium.
This is how creation and redemption mechanism in an ETF is used to ensure liquidity and arbitrage premiums and discounts.
When making a purchase or sale of an ETF, the most relevant factor is its real-time nature of trading. Even though the AUM and trading volumes can help one evaluate liquidity, they should not be taken as the only indicators.
Let’s look at exactly what ETF liquidity is. It’s important to note that, even though ETFs are traded similarly to stocks, they are not the same.
Secondary market liquidity: Secondary market liquidity can be seen on your trading platform; the gap between bids and offers provides information about existing liquidity. Have a look at this illustration comparing Mirae Nifty 50 ETF with LIC Nifty 50 ETF. The former holds an AUM of Rs 618 crs, while the latter has a value of approximately 483 crs. At the time of this post, both ETFs had just traded over 500 units.
Generally it’s best to overlook ETFs when you think they’re too tiny and don’t trade often. However, that assumption is inaccurate because reality doesn’t always reflect the liquidity portrayed on-screen.
ETF market depth: It’s easy to see that the Mirae ETF has a significant amount of liquidity, with nearly 60,000 shares ready to buy. Placing a market order, while not the best strategy, would still yield a good fill at Rs 157.44 – likely due to a market maker quoting both sides of the trade. The story is quite different for the LIC ETF though; there is virtually no liquidity meaning that any market order is sure to have an inflated cost as it’s executed over multiple prices.
AUM and trading volume don’t tell the whole story. Market makers usually have units that don’t appear in the market depth. Placing a limit purchase order will ensure your trade is conducted as the market maker puts in an order to sell. However, not all ETFs have active market makers, which should be taken into account when you are researching them, something we will touch on soon.
Mirae and LIC ETFs have tracked the Nifty 50 differently. The former has mostly kept pace with the index, while the latter has been volatile, trading at prices both above and below its value.
Primary market: The primary market provides a third layer of ETF liquidity. While stocks have a set number of shares available, ETFs can be created through the actions of market makers, investors and large institutions. High Net Worth Individuals usually bypass the exchange and buy ETFs directly from the AMC, meaning these transactions do not appear on trading platform market depths.
Liquidity of the underlying stocks: The liquidity of the stocks that constitute an ETF is the most critical factor to consider. An ETF consists of a bundle of stocks or an index, and its liquidity is essentially dictated by those stocks.
This might be perplexing, so let’s look at an example. Why do we not have a small-cap ETF in India? Well, the liquidity of the 200 largest stocks quickly dissipates when looking lower down the market cap. Typically, those smaller stocks come with less outstanding shares and lesser trading volumes that commonly hit upper and lower circuits.
Assuming there was a surge in demand for a small-cap ETF, the market maker would need to generate units to fulfil it. However, if some of the essential stocks are not liquid or have reached their set limit, they cannot be used to manufacture more. Thus, the ETF will likely be priced higher than the NAV since there will be an increase in requests for the existing units. Not only small-caps but mid-caps in India usually do not have much liquidity either. Consequently, an ETF can just provide as much liquidity as its underlying stocks. On the other hand, a large-cap ETF such as Nifty 50 is not affected by this due to higher liquidity of primary stocks included in it.
In conclusion, trading volumes and AUM are both taken into consideration when examining an ETF, but they do not provide the full picture.
Like I mentioned at the start of the chapter, ETFs are pretty new in India, we have about 88 ETFs today. A majority of them are equity ETFs. Here are your ETF choices:
Here’s a list of all Indian ETFs.
This is a common query that keeps surfacing. Presently, the main ETFs available in India are passive ones which track either the Nifty 50 or Sensex 30. However, smart beta ETFs aren’t strictly passive as they still monitor an index, but more like a combination of active and passive strategies we went over in the smart beta chapter. In general, around 80-90% of all ETFs are passive across the world but the US has recently experimented with traditional active ETFs. Who knows? We may eventually see them here too! To conclude, not all ETFs need to be passive – it’s just that they are today.
This has been a long discussion, but it was to ensure you have all the information needed before putting money into an ETF and avoid unpleasant surprises. It is my hope that you now have a firm grip on how ETFs function and their mechanics. So let us head on to examining some points to bear in mind when investing in an ETF.
It cannot be stressed enough: never use a market order when investing in an ETF. This is an unfortunate error that many investors have been guilty of making. To demonstrate the grave implications of this mistake, consider the Aditya Birla Sun Life Nifty Next 50 ETF. If one had put in a market order for 200 units, their order would start to be fulfilled at Rs 350 – above the LTP – and end up at Rs 374, which is 8.7% more than the LTP! So please, remember to use limit orders only!
It’s important to use the iNAV as a reference when placing a limit order on an AMC website. If the site isn’t updated or down, one should compare the ETF with its underlying index on Kite first. Any major discrepancies between the last updated iNAV and current market price is an indication of something being off. Therefore, it’s best to reach out to the AMC for confirmation before executing any buy or sell orders.
The Nippon NiftyBeEs ETF has demonstrated close tracking of its NAV; you can verify this on Value Research. Ultimately, when selecting an ETF to invest in, it is best to look for one that follows the underlying index as closely as possible. Soon, Coin will provide a feature allowing comparison of price and NAV.
It can be difficult to grasp what a tracking error of 0.02% means, which is why AMCs disclose it on their factsheets. Analysing an ETF properly requires looking at the difference between its price and the underlying index – you want it to stay consistent with minimal discrepancies. The NAV and the selling price might differ, but this gap should be kept as small as possible.
Note: Always compare the ETF price with the total returns index (TRI) and not the price returns the index (PRI). The TRI includes dividends. All the index data you see on Kite is PRI. Since ETFs track TRI indices, they reinvest the dividends which reflects in the NAV of the ETF.
Invest in an ETF that has sustained volumes over time. Edelweiss ETF – Nifty 100 Quality 30 is a good example, with monthly average volumes of 150 units. To confirm, you can use Kite to view the volume chart and apply a moving average to check the average volumes. If you had chosen this ETF and needed to exit later, it’s likely that you wouldn’t have been able to due to lack of sufficient trading activity.
ETFs tend to have low trading activity during the first 30 minutes to 1 hour after the market opens. During this time, orders for only a few units can cause prices to move abnormally. For this reason, it is best to avoid placing any trades during this period if possible. If necessary, traders should use limit orders and verify the iNAV before entering into a position.
Most AMCs offer ETFs these days, however, it doesn’t necessarily mean that they are committed to maintaining and growing their ETF options. Nippon, ICICI, and SBI typically handle the bulk of the ETF volumes. Conversely, AMCs like Mirae and Edelweiss are dedicated to developing a full suite of ETF offerings with their debt ETFs as a prominent feature. Therefore, when performing due diligence checks, investors should also analyze an AMC’s commitment to its current lineup of ETFs. For instance, Aditya Birla Mutual Fund, IDBI, LIC, and Indiabulls have an alarming tracking error rate coupled with very low trading volumes.
It’s beneficial to approach the AMC for unit creation if your investments in ETFs exceed the creation basket value, rather than buying on the stock exchange.
This question has been asked repeatedly. To provide a clearer understanding of the answer, this table should act as a guide. ETFs are preferable if one is actively managing their investments or are already utilising passive ETFs. On the other hand, index funds may be more suitable for those who want to limit the amount of decisions they need to make. I myself fall into this last category.
ETFs enable you to apply tactical moves more effectively than index funds, as they can be bought and sold without delay.
Earlier in the index funds chapter, we saw that over the last 10 years or so, ETFs and index funds have grown increasingly popular. The primary cause of this is more investors realising that most actively managed mutual funds fail to exceed their benchmarks. The US is a foremost example: 90% of active funds do not surpass their standards.
Merging these entities into one, the Indian markets have become highly professionalised with the share of institutional investors being large. As a result, much of the informational gaps and discrepancies have been bridged. In addition, everyone has access to the same data now; in essence, it is hard to anticipate movements in major stocks through single pieces of information. The probable largest causation for active funds underperforming lies in their expensive fees.
On average, actively managed large-cap funds levy a fee of 1.5%, whereas a Nifty 50 index fund requires only 0.10%. And the numbers back this up. The S&P SPIVA report demonstrates that in any period, over 70% of all large-cap funds underperform their benchmarks.
Traditionally, the mid-cap and small-cap space was viewed as an inefficient area for stock pickers to thrive. However, over the course of the last 5 years since SEBI’s categorization exercise, active mid-cap funds have had difficulty matching up to benchmarks like Nifty 50, BSE/NSE Mid-cap 150 index or Nifty Next 50 etc. This data is merely provided as an illustration, and it is recommended that rolling returns should be taken into account.
Overall, the majority of actively managed funds fail to beat passive ETFs and index funds such as Nifty 50, Nifty Next 50 and Nifty Midcap 150. A combination of high costs, rigid internal mandates, and market efficiency make it difficult to outperform these benchmark indices. What’s more, it is virtually impossible to select those funds whose performance will outdo their peers over the long term; past winners often become tomorrow’s laggards.
It’s become obvious that index funds are a smart bet in the large-cap realm. The same looks to be true with mid-caps, too. But when it comes to small-caps, the risks involved necessitate a different approach: actively managing both an investment fund and timing are essential.
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