Explained: How do ETFs work?

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.

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.