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Explained: How do ETFs work?

Index re-balancing, lack of liquidity in index constituents, can lead to tracking error.

December 22, 2021 / 09:07 AM IST

This year, the mutual fund (MF) industry launched 18 exchange-traded funds (ETFs), ranging from those that invest abroad to those that follow factor-based investing, some others that invest in sectors or themes, and so on. But often investors ask if they should pick an ETF or an index fund.

How are ETFs different from index funds?

Both index funds and ETFs are passive funds. Both funds do not aim to outperform or underperform their benchmark indices. An ETF, like an index fund, chooses a benchmark index and then mimics the benchmark’s returns. That’s where the difference ends.

An ETF is available only on the stock exchange, where you can buy and sell during market hours. Index funds also aim to match the returns of an underlying index. But they don’t offer intraday buying or selling prices to investors. The funds’ net asset values (NAVs) are released at the end of day. The investor can only get that day’s NAV when her investment gets credited in the fund, as per the Securities and Exchange Board of India’s new regulations. This may take a couple of days or even more, depending on the mode and time of your investment. ETFs on the other hand are traded like stocks, so investors can buy or sell the ETF at the traded price prevailing at the time of placing the order.

Why are ETF tracking errors typically lower than that of index funds?

An ETF’s structure is considered better than an index fund’s. An index fund works like a typical MF scheme. When investors put money into the fund, the fund buys the underlying securities in a way that the portfolio as closely resembles the underlying index as possible. The fund manager holds some cash in the fund. The larger the cash component, the more the scheme’s deviation from its benchmark’s performance. Although the index fund manager tries her best to keep the cash component to a bare minimum, sometimes money doesn’t get deployed instantly. This leads to a tracking error.

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An ETF unit in contrast is created only by exchanging the basket of securities with the fund house. The constituents of a unit basket are fixed and cannot be changed; typically, underlying securities and a little bit of cash. This keeps an ETF’s cash component firmly in check and, hence, leads to lower tracking error.

To be sure, large investors can directly exchange their basket of shares with the fund house, but they need to have the basket as exactly specified.

Who creates the ETF liquidity on the stock exchange, then?

Here’s where market makers play an important role in an ETF’s life cycle. Fund houses appoint market makers for each of their ETFs to create liquidity on the stock exchanges. These are individual brokers who create (and extinguish) units directly with the fund house so that retail investors can get to buy and sell them easily, and whenever they want, on the exchange.

ETFs also publish intraday NAVs (iNAVs), which are updated by the MFs throughout the trading session. The iNAV is the real-time value of the ETF on the basis of the value of the holdings in the index.

That means an ETF is a winner. Can we just dump all our index funds and switch to ETFs, now?
Not quite. An ETF can be costlier than an index fund. Since ETFs can be bought and sold only on stock exchanges, you need a demat account (charges are Rs 300-450 per annum). (For active investors or traders, these charges are sometimes waived.) There are brokerage charges as well; most charge up to 0.5 percent per trade. If you are taking delivery of the ETF (that is, not using it for trading over a day or two), discount brokers don’t charge any fees for such transactions.

ETFs with low market volumes lack liquidity since you may not find a sufficient number of buyers when you wish to sell your stock, or enough sellers when you want to buy some units, and lead to impact costs for investors. The difference in the price you actually end up paying versus the scheme’s NAV is the impact cost. For instance, the impact cost for Nippon India ETF Nifty BeES on the National Stock Exchange was 0.03 percent (December 17, 2021).

How to measure an ETF’s performance?

Passive funds are best measured by their tracking errors or the deviations in their performance from their respective benchmark indices. Over the years, as fund houses and markets have matured, tracking errors of passive funds, especially index funds, have shrunk.

There can be other causes of tracking errors, though. Whenever the underlying constituents of an index change, those stocks’ prices can be volatile. This also makes the job of replicating the index difficult on such days.

Lack of liquidity in the stocks in the underlying index also contribute to tracking error as buying and selling can cause high impact costs. That is why a small-cap and mid-cap passive fund’s tracking error is typically higher than that of a large-cap fund.



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Jash Kriplani is a journalist with over ten years of experience. Based in Mumbai. Covering mutual funds, personal finance. His last stint was with Business Standard, where he covered mutual funds and other developments in the financial markets
first published: Dec 22, 2021 09:00 am
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