Exchange-traded funds (ETF)

29.1 – Overview 

In chapter 7, we looked at what a mutual fund is and how it works. To recap, a mutual fund is a pooled investment vehicle that collects the money from various investors, invests and manages that money on their behalf. When you invest in a mutual fund before the order placement cut-off time, you will get the units as per the same day’s NAV which is disclosed by midnight. If you invest after the order placement cut-off time, you’ll get the allotment of units per the next day’s NAV. Basically, everything happens at the end of the day.

Now, what if those mutual funds units could be traded on the stock exchange just like stocks like Reliance or Infosys? Just like a mutual fund, an exchange-traded fund (ETF) is a pooled investment vehicle that holds a basket of securities like stocks, bonds, and commodities and trades on the stock exchanges. You can buy and sell an ETF anytime, just like a stock.

There are a few more nuances to an ETF than a mutual fund, but before we dive in, I hope you have a working idea of what an ETF is.

29.2 – History of ETFs

Mutual funds have been around in some form for well over 100-years. The first open-ended mutual fund in the US was launched in 1924 and is still in existence today. The first mutual fund in India was launched in 1964. Mutual funds have democratized access to stocks, bonds, real estate and commodities globally to common investors. Exchange-traded funds (ETF) were the next evolution of mutual funds.

ETFs, on the other hand, are relatively new. The SPDR S&P 500 trust, arguably the first ETF, was launched in 1993 in the US. Coincidentally, it is today the largest traded security in the world. NiftyBeES an ETF tracking the Nifty 50 index was the first ETF in India and was launched in 2002. It was launched by Benchmark AMC, which Goldman Sachs later acquired, which Reliance later acquired, which Nippon India Mutual Fund later acquired ????

29.3 – ETFs in India

Though ETFs have been around for a while in India, they haven’t really popular among retail investors. ETFs, have mostly been used by HNIs and institutions. For example, the SBI Nifty 50 ETF with Rs 89,441.55 cr is the largest mutual fund in India. This is almost entirely because this is one of the ETFs in which the Employees’ Provident Fund Organisation (EPFO) invests.

A large part of the ETF AUM growth is due to:

• EPFO investing in Nifty & Sensex ETF
• Government divestment through CPSE ETF and Bharat 22 ETF

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:

1. India is still a tiny market. We just have about 1.7 crore active demat accounts, and unlike a mutual fund, you can only buy an ETF if you have a demat account.
2. Investment products, be it mutual funds or ETFs are push products. One of the reasons why mutual funds are larger than ETFs is because AMCs can pay distributors & platforms commissions to sell their mutual funds. But ETFs don’t have commissions like mutual funds.
3. ETFs are also relatively trickier to understand initially compared to mutual funds. But we’ll take care of that with this chapter.
4. Most AMCs, rarely push ETFs because they have low margins and don’t make sense with small AUMs.

29.4 – What is an ETF?

An exchange-traded fund (ETF), just like a mutual fund is a basket of securities, but this is where the similarity with a mutual fund ends. Unlike a mutual fund, an ETF trades throughout the day on the stock exchanges. You can buy and sell an ETF anytime you want just like a stock.

29.5 – How does an ETF work?

When you buy a mutual fund, the AMC takes money from you and buys the securities and discloses the NAV at the end of the day. Similarly, when you redeem your mutual funds, the AMC sells the securities and returns your money. This is quite straightforward. However, when you buy an ETF, you don’t really interact with the AMC most of the times because most buying and selling happens on the stock exchanges. It’s just an exchange of units between buyers and sellers.

29.6 – Creation and redemption mechanism

I said when you buy an ETF, you “mostly” don’t interact with the AMC and I’ll explain what that means. If you remember chapter 6, we discussed all the entities involved in an MF transaction — the AMC, custodian and the RTA. But what makes an ETF unique is something called the creation and redemption mechanism. But before we talk about it, you need to know a couple of things.

1. NAV, iNAV, the market price
2. Market makers and authorized participants
3. Creation units
4. Premiums & discounts
5. Tracking error

Market price

When you buy a mutual fund, you look at the NAV. Similarly, when you are buying an ETF, you look at the ETF market price on Kite.These prices are determined by the demand, supply and the trading activity on the exchanges. But how do you know if the price you see on Kite is the fair price you are paying for an ETF? Here’s where the Net Asset Value (NAV) comes in.

Net asset value (NAV)

Like a mutual fund, an ETF also has an end of the day Net Asset Value (NAV). Just to refresh your memory, NAV tells you the total value of all the fund’s assets and yours. The formula for calculating NAV is NAV = (Value of all the assets – the expenses)/number of shares (units). But remember, an ETF trades real-time, whereas NAVs are only announced at the end of the day. So how do you figure out if the price you are paying for an ETF is fair in real-time? Enter iNAV

Intraday or indicative net asset value (iNAV)

Given that ETFs trade real-time, you need a reference point to see if the market price you see on your trading platform is a fair one and the indicative or intraday NAV (iNAV) serves as that reference. AMCs usually calculate this every 10-15 seconds and publish it on their websites. iNAV = last traded price of all the securities in the ETF basket X number of shares in the ETF creation basket + cash component (i.e. cash which is not deployed in the ETF) divided by total ETF shares in the creation basket. Put simply; this serves as a real-time NAV so that you can use this as a fair value reference to compare it with the current market price on the stock exchanges.

Creation unit

Like buying ETF units on the stock exchange, you can also buy units directly from the AMC. I’ll explain why you’d want to do that later. But, unlike the exchanges, you cannot buy 1 or 2 units directly from the AMC. You can only create and redeem units in what’s called the creation size that the AMC defines. A creation unit is nothing but a representative basket of all the securities in the same proportion as the underlying index. For example, the creation unit size of the ICICI Nifty 50 ETF is 50,000 units, and as of this writing, it’s about Rs 80 lakhs. Meaning, you need 80 lakhs to buy all the stocks in Nifty 50 in the same weight.

Market makers and authorized participants (APs) 

Unlike mutual funds, there’s another entity called market markers or authorized participants in the ETF ecosystem. The role of these guys is to provide liquidity on the stock exchanges. You don’t have to worry about liquidity in a mutual fund because there’s no real-time trading. But since an ETF trades real-time on the exchange, market makers are appointed by the AMC to provide liquidity continuously. They do this by providing continuous two-way quotes on the exchange, meaning they buy at the bid and sell at the offer, and the difference is the profit they make. Even though these are small amounts, since they keep doing this, it tends to add up.

Market makers typically tend to be large brokers in India.

Premiums and discounts

Since an ETF trades real-time on the exchanges, their price is influenced by demand and supply—the prices of liquid ETFs trade in line with the NAV of the ETF most of the time. But sometimes, particularly during volatile market phases, the price of an ETF can trade away from the NAV of the ETF. If the price of an ETF is above its NAV, it’s called a premium and if the price is below it’s NAV, it’s called a discount.

Tracking error

Tracking error is the annualized standard deviation of the difference between the ETF NAV returns and the index that it tracks. In simple terms, it shows you how closely an ETF tracks its underlying benchmark. A simple example would be if Nifty 50 returned 10% and Nifty ETF gave 9.8%, the tracking error would be 0.2%. An ETF or an index fund will have lower returns than the index because they have an expense ratio and an index doesn’t.

A lower tracking error indicates that an ETF or an index fund is tracking the index better. But this is not really an intuitive measure to understand and we’ll discuss that later.

With these concepts in mind, let’s get back to the concept of creation and redemption mechanism

There are a few reasons why the creation and redemption mechanism is important. For one, you need not always buy an ETF on the stock exchange. If you are buying in multiples of the creation unit size, buying it directly from the AMC is way better because you might face liquidity issues and impact costs when you buy large quantities on the exchange.

So, in the example I mentioned above, the ICICI Nifty 50 ETF’s creation size is roughly 80 lakhs. If you are investing in multiples of 80 lakhs, you can directly contact ICICI, and they will create units, in this case, 50,000 units and credit them to your demat. The AMC will create units at the iNAV.  Similarly, you can redeem them by transferring the ETF units to ICICI, and they will credit the cash to your bank account or you can also get the underlying shares instead of cash.

The second reason why creation and redemption mechanism important is for ETF arbitrage. Like I mentioned earlier, ETFs can trade at premiums and discounts to the NAV. Market makers are essential in the ETF ecosystem because they are responsible for correcting these premiums and discounts. They do this through the creation and redemption mechanism.

Typically ETFs trade close to their NAVs. Here’s a comparison of Nifty BeEs, SBI Nifty ETF, ICICI ETF and Nifty 50.

But during a volatile market phase, for example, like the COVID crash in 2020, there can be wide premiums and discounts. Here’s how even a popular ETF like NiftyBeEs and SBI Nifty 50 ETF, India’s largest mutual fund performed during the volatile market phase of March-April 2020.

Now, here’s where the market makers come in. If there’s a premium, the authorized participant (AP) will buy all the underlying securities that make up the ETF creation unit. In this case, the AP will buy all the 50 Nifty stocks of the same weight; this is also called the creation basket and give them to the AMC. In turn, the AMC will create ETF shares and give them to the AP, who will then sell them on the exchange.

Similarly, if there’s a discount, the AP will buy the ETF units on the exchange and give them to the AMC. In return, the AMC will give the underlying shares of the ETF to the AP, who will, in turn, sell them in the market. The difference between the premium, discount, and the NAV will be the AP/market maker’s profit.

Perhaps, the best example of this would be the Motilal Oswal NASDAQ 100 (N100). During 2017-2018, the ETF was trading at a huge premium to the NAV. The premiums were as high as 20%+. This was probably because the market makers weren’t active in providing liquidity. Value Research allows you to here’s a chart, notice the huge difference between the NAV and the price.

Someone could have taken advantage of this premium by going to Motilal AMC and asking them to create units, which happens at the NAV and sell them at the market price on the exchange. The difference would’ve been the profit.

This premium persisted for a long time. Then Motilal, If I’m not wrong, appointed new market makers and launched a fund of fund (FOF) for the ETF, which corrected the premium. So the market maker around 2018 would have created Motilal units at the NAV and sold them on the exchange at the market price and corrected the premium.

This is how creation and redemption mechanism in an ETF is used to ensure liquidity and arbitrage premiums and discounts.

29.7 – ETF liquidity

This is the most important thing when buying or selling an ETF because they trade real-time. When choosing an ETF, most people tend to look at the AUM of an ETF and the trading volumes to decide if an ETF is liquid. Although these 2 things should be considered, the size of an ETF or the daily trading volumes alone don’t indicate liquidity.

Let’s unpack what ETF liquidity really means. It’s essential to remember at this point that even though ETFs trade like stocks, they are not the same.

Secondary market liquidity: This is what you see on your trading platform. The spread between the bids and offers give you an idea of the available liquidity, but that’s not all. Take a look at this image, comparing Mirae Nifty 50 ETF and LIC Nifty 50 ETF. The LIC ETF has an AUM of Rs 618 crs, and the Mirae ETF has about 483 crs. As of writing this post, both the ETFs had just traded 500+ units.

Typically, you’d ignore both ETFs assuming that they are too small and don’t trade much. But that would be an incorrect assumption because on-screen liquidity isn’t everything.

ETF market depth: If you look at the Mirae ETF, nearly 60,000 shares are available for purchase. That means, even if you place a market order, which is a really terrible mistake when buying an ETF, you will get a good fill at Rs 157.44. This is probably a market maker posting a bid and an offer. The LIC ETF, on the other hand, has no liquidity at all. If you’d have placed a market order for 100 unit by chance, your average price would have been way higher than the last traded price, given that there are no volumes and your order would’ve been continuously executed at higher and higher prices.

So, AUM and trading volumes don’t tell you everything. Market markers typically hold units that don’t show up in the market depth. If you place a limit order to buy, your order will be executed as the market makers place an order to sell. But yeah, not all ETFs have active market makers, this has to be part of your ETF due diligence which we’ll talk about in a bit.

Here’s how the Mirae ETF and LIC ETF have tracked Nifty 50. While Mirae has closely tracked Nifty 50, LIC has been all over the place trading at premiums and discounts.

Primary market: The third layer of ETF liquidity is the primary liquidity. Remember, a stock has a fixed number of shares on offer, But even though an ETF trades like a stock, it’s not a stock. Market makers and investors can create new ETF units. Large institutions, HNIs, typically don’t buy ETFs on the exchange. They directly reach out to the AMC and create units that don’t show up on your trading platforms’ market depth.

Liquidity of the underlying stocks: The last and the most important layer of ETF liquidity is how liquid the underlying stocks that make up an ETF are. Remember, an ETF is just a wrapper that holds all the stocks that make up the ETF or an index. So, an ETF can only be as liquid as the underlying stocks.

This might be a little confusing, so let’s take an example. Today, in India, we don’t yet have a small-cap ETF, have you ever wondered why? In the Indian markets, the liquidity quickly starts disappearing after the 200 largest stocks. As we go down the market cap, the smaller stocks tend to have less outstanding shares, less trading volumes, and usually keep hitting upper and lower circuits.

So, assuming there was a small-cap ETF and that there was a sudden spike in demand, the market maker would have had to create units to satisfy the demand. Now if some of the underlying stocks are not liquid or have hit circuits, which is quite common in small-caps, he wouldn’t have been able to create units. In such a case, the ETF will probably trade at a premium to the NAV because there will be more demand for the existing units. Not just, small-caps, even mid-cap stocks in India have liquidity issues. So, an ETF can only be as liquid as it’s underlying stocks. But this isn’t a problem in a large-cap ETF like a Nifty 50 ETF because these are the biggest and the most liquid stocks.

To summarize, trading volumes and AUM are factors, but they don’t tell you everything about an ETF.

29.8 – ETF choices in India

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:

1. Equity ETFs
   There broadly 2 sub-categories of equity ETFs. You have your plain vanilla market-cap-weighted ETFs that track indices like the Nifty 50, Nifty 100, Sensex etc. And then you have smart beta ETFs which target factors such as value, quality, low-volatility, momentum etc.
2. Debt ETFs
   We have debt G-sec ETFs, Bharat bond ETF which just holds bonds issued by PSUs, and then you have an ETF like the CPSE+SDL ETF by Nippon which holds PSU bonds and State development loans (SDLs).
3. Commodity ETFs
   For now, we just have gold ETFs.

Here’s the list-

Are all ETFs passive?

This is a common question that keeps coming up. Today, the biggest ETFs we have are passive ETFs that track either the Nifty 50 or Sensex 30. But smart beta ETFs aren’t passive, even though the ETFs track an index. They are more of a hybrid of active & passive like we discussed in the smart beta chapter. Globally, 80-90% of all ETFs are passive, but we see the first traditional active ETFs in the US. Maybe, we’ll eventually see them in India as well. So ETFs need not be all passive, it’s just that they are passive today.

ETF due diligence

I know this has been a little long, but the idea was to give you the full context you need before investing in an ETF and help you avoid rude surprises. And I hope at this point; you have a clear understanding of how an ETF works and its mechanics. With that in mind, let’s now look at some things you should consider before you buy an ETF.

Always use limit orders

I cannot stress this enough but never use market orders when buying an ETF, always use limit orders. This is one mistake I see investors constantly make. We saw this earlier but let me reiterate this with an example. Take a look at the market depth of Aditya Birla Sun Life Nifty Next 50 ETF. If you placed a market order for 200 units, your order would be executed at prices starting from Rs 350, which is above the LTP, to begin with, and finally, at Rs 374, that’s 8.7% higher than the LTP.  So, always use limit orders.

Always check the iNAV

Always look at the iNAV on the AMC website and place a limit order at that level. Don’t just place a limit order without looking at the iNAV. The other issue is that sometimes AMC websites don’t update their iNAVs or their websites might be down. If there is a big difference between the last updated iNAV and the current market price, that’s a sign that there is something wrong. So, make sure to compare the ETF with the intraday chart of the underlying index of the ETF on Kite, and that will give you an indication if the price is correct. Check with the AMC in such a case before placing an order.

Compare the NAV and the price of an ETF and see how it has performed

You should always buy an ETF that tracks the underlying index as closely as possible. Here’s how Nippon NiftyBeEs ETF has tracked it’s NAV, it’s pretty close. You can compare the price and the NAV on Value Research; we’ll try having this feature on Coin.

Picking up on the earlier point about the tracking error, AMCs disclose the tracking error on their factsheets. But if you see a tracking error as 0.02%, it’s hard to understand what it means. Moreover, AMCs calculate the tracking error on the NAV, but you buy and sell based on the price, which can be totally different. So the best way to analyse an ETF is to look at the difference between ETF prices and the underlying index. You want the price of ETF to track the index consistently without huge differences.

Note: Always compare the ETF price with the total return value 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 re-invest the dividends which reflects in the NAV of the ETF. 

Look at the average volumes

Look at the average volumes over a period of time and see how an ETF has traded. You should invest in an ETF that trades regularly. You should avoid ETFs that just have a brief spike in volumes and then don’t trade. The Edelweiss ETF – Nifty 100 Quality 30 is an example. The monthly average volumes are about 150 units. You can check the average volumes by applying a moving average on the volume chart on Kite. So assuming you had bought this ETF and had to exit, you most likely wouldn’t have been able to.Avoid buying and selling at market open

Most ETFs don’t trade much for 30 mins to 1 hour of the market open. They also tend to trade at abnormal prices because of the low volumes, even orders for a few units can move prices. If you can, avoid trading in the open. And if you have to, check and verify the iNAV and use limit orders.

Is the AMC focussed on ETFs?

Today, most of the AMCs offer ETFs but doesn’t mean they are serious about them. Most of the ETF volumes are in ETFs offered by Nippon, ICICI, and SBI largely. Other AMCs like Mirae, Edelweiss with their debt ETFs do seem serious about building out their ETF offerings. So, along with the other things on the due diligence list, you’ll also have to look at whether an AMC is serious about the ETFs it offers. For example, if you look at some of the ETFs by Aditya Birla Mutual Fund, IDBI, LIC, Indiabulls etc., they have horrible tracking errors and almost no volumes.

Creating units with the AMC for higher-value investments

If your investments in ETFs are equal to or more than the creation basket value, it’s better if you approach the AMC to create units rather then buying on the stock exchange.

29.9 – ETF vs index funds

This is another question that keeps coming up. Hopefully, this table should help answer these questions. In short, if you want to have active control or if you are actively using passive ETFs, then ETFs are a better choice. But if you are lazy like me and want to make as fewer choices as possible, then index funds are a better choice.

With ETFs, you can express tactical strategies better than index funds because you can’t buy and sell index funds immediately.

29.10 – Performance of ETFs vs actively managed funds

We discussed this earlier in the  as well. In the last decade or so, index funds and ETFs have become increasingly popular around the world. One reason is that investors have increasingly realized that a vast majority of actively managed mutual funds don’t beat their benchmarks. In a developed market like the US,  ~90% of active funds don’t beat their benchmarks.

The Indian markets have grown a fair bit and have become increasingly professionalized; institutional investors are a big part of today’s market. This means that most of the informational edges and asymmetries have been arbitraged away. Today, pretty much everyone has access to the same information. The odds of someone finding some piece of information that can move a stock, at least in the large-cap space, for example, is pretty much zero. But perhaps the biggest reason why active funds underperform is that they charge too much.

Actively managed large-cap funds on an average charge~1.5% whereas a Nifty 50 index fund is available for 0.10%. And we see this in the performance. S&P publishes a report called SPIVA, which measures the performance of active funds. For any period, over 70% of all large-cap funds fail to beat their benchmarks.

Traditionally, the view was that the mid-cap and small-cap space was inefficient, and this was where stock pickers thrived. While this was true, it seems like this is increasingly becoming less so. In the last 5 years since the SEBI categorization exercise, active mid-cap funds have had a tough time keeping up with a broad mid-cap benchmark like the Nifty 50 or BSE/NSE Mid-cap 150 index and even Nifty Next 50 etc. Here’s a quick look, this is just for illustration, and ideally, you should look at the returns.

The bottom line is that most actively managed funds don’t outperform a simple broad-market ETFs or index funds like Nifty 50, Nifty Next 50 and Nifty Midcap 150. This is due to a combination of high costs, increasing market efficiency, and internal fund mandates to not deviate too much from the indices. Moreover, it’s tough to pick those funds & managers that beat their benchmarks. And even if you figure out how to pick a winning manager, there is very little persistence in performance. The best performing fund often ends up being the worst-performing fund over a period of time.

Today, it’s a no-brainer to look at index funds in the large-cap space. There’s increasing evidence that it’s the same in the mid-cap space as well. As for small-caps, these are severely risky and buy and hold may not be an optimal strategy, and active management both in a fund and in timing is needed.

Key takeaways from this chapter

• ETFs trade real-time on the stock exchanges and you can now set-up SIPs in ETFs to invest every month
• Blindly choosing an ETF is a bad idea. ETF due diligence before investing is extremely important
• ETF liquidity is an issue in India because our markets are still small and this needs to be kept in mind when buying and selling
• Always use limit orders and compare the market price of the ETF with the intraday or indicative NAV (iNAV) before buying and selling
• You can check the iNAV on the respective AMC’s website
• Sometimes the iNAVs on AMC sites may be wrong. If the difference between iNAV and the price is huge, it’s a red flag.
• Compare the ETF price with the underlying index or check with the AMC in cases where the ETF prices are way off from the iNAVs/NAVs
• Large-cap and mid-cap Index ETFs make a lot of sense vs actively managed large-cap and mid-cap index funds