How do ETFs function and why they may be the right instrument for long-term investors

Updated: Jul 23, 2019 1:17 PM

ETFs have taken the world by storm and are also seeing increased adoption in India as investors learn of their various advantages.

Exchange traded fund, ETF, etf vs mutual fund, ELSS, mutual fund, NFO, While liquidity was definitely a concern in the nascent stages of the ETF market in the early 2000s, the ETF market has become much larger in recent years.

Exchange-traded funds (ETFs) have already taken the world by storm and are now also seeing increased adoption in India as investors learn of their various advantages – like lower costs, increased transparency, ability to transact anytime like stocks, etc. Still, many Indian investors have thus far stayed away from investing in ETFs as they believe ETFs are illiquid – i.e. there aren’t enough people trading ETF units, and as a result, investors have to pay more than the NAV of the unit (i.e. higher bid/ask spread) in order to buy/sell the ETF units.

This is a known market risk when trading large positions of any stock – if the stock doesn’t have enough sellers (when you want to buy), the price ends up increasing and the cost increases due to lack of supply/sellers. But unlike stocks, liquidity in ETFs can easily be created by special market-makers called Authorised Participants (APs), who are pre-appointed by AMCs to provide ETF liquidity on exchanges. In theory, this makes an ETF practically as liquid as the underlying stocks it invests in.

How is ETF Liquidity created?

Mutual funds have a subscription/ redemption process that usually takes 1-2 days, where the particular AMC issues/redeems units to investors. While AMCs also issue ETF units that have a NAV, these units can be bought & sold instantly over an exchange, thus providing instant liquidity.

The reason ETFs can provide this liquidity is because of something known as the “creation/redemption” process of ETF units, which involves third-parties called Authorised Participants (Aps). When an AMC wants to create new ETF units, whether it’s for a New Fund Offering (NFO) or to meet increasing demand for an existing fund, it turns to these third-party APs – they can be a brokerage (like Edelweiss Securities Ltd.), specialist capital-markets firms (like Parwati Capital Market Pvt. Ltd.) or other large financial institutions that have significant buying power in the opinion of the AMC.

The AP acquires the stocks/securities the ETF wants to hold – for example, when an ETF that tracks the Nifty-50 or BSE-100 wants additional ETF units due to increased demand, the AP will buy the underlying shares of the respective indices in the exact weightage as they are in that index. The AP will deliver these shares to the AMC who maintains the particular ETF, and in exchange receive a block of ETF units of the same value.

The price of the ETF units handed to APs is based on the NAV – and not the market value at which the ETF happens to be trading. But the AP gets to sell these units in the open market, thus earning a spread (the price in excess of NAV).

Both the AMCs and the APs benefit from the transaction: the AMC receives the stocks it needs to keep their ETF in-line with the index/strategy, and the AP receives ETF units to resell for a spread & earn profits.

This process also works in reverse, i.e. when the AMC wants to redeem units or when there are more sellers than buyers. In this case:

● The AP buys ETF units from the market in large blocks, usually costing below the market price

● These blocks are then delivered to the AMC for redemption

● In return, the AP gets the underlying shares/securities of same value

● The AP then sells these units in the open market to earn a premium

The Inherent Fairness of ETFs

This creation/redemption process is exactly what makes ETFs inherently fairer than mutual funds.

Mutual funds incur trading costs in the following cases:

1. The initial set of stocks purchased when the mutual fund scheme is being launched, i.e. during the NFO

2. Any subsequent buying/selling of stocks due to the views of the fund manager, which can be fairly frequent

3. Any subsequent buying/selling of stocks each time investors subscribe/redeem from the funds – which is daily

All these activities incur trading costs, which negatively impacts the returns of the fund, ultimately reflected in lower NAV & impacting all investors. Unfairly enough, even if you decide to buy-and-hold to your investment, you will still be bearing the costs incurred due to the behaviour of other investors who trade in/out of the fund (as in case #3).

The trading costs associated with ETFs, however, is different as the fund itself only incurs the first 2 costs. First, when the fund is being launched & the initial set of stocks need to be purchased, and subsequently when the fund composition changes, which in the case of ETFs happens only when the index composition changes (which is every 6 months for most indices).

Existing investors in the fund only pay for these 2 costs – and not the costs associated with other people entering/exiting. If any investor wants to exit, or an investor wants to invest in the ETF, this additional cost is borne by the particular investor alone via the bid/ask spread. The ETF itself – and its existing investors – remain shielded from the associated trading costs.

What Should Retail Investors Do?

While liquidity was definitely a concern in the nascent stages of the ETF market in the early 2000s, the ETF market has become much larger in recent years. Inflows encouraged by the Government (via Bharat-22 & CPSE ETFs) and the Employees’ Provident Fund Organisation (EPFO) have especially boosted the ETF liquidity. This trend is likely to continue due to the numerous advantages of ETFs over mutual funds.

FM Nirmala Sitharaman’s Budget 2019 also recognised their contribution, saying “ETFs have proved to be an important investment opportunity for retail investors…Government will offer an investment option in ETFs on the lines of Equity Linked Savings Scheme (ELSS).”

This will undoubtedly spur the ETF market even more in the coming years. But here’s the beautiful twist – even if liquidity doesn’t improve instantly & bid/ask spreads remain slightly higher than the NAV, remember that you only pay that if/when you transact. If that is not too frequent, think of all the money you will save in lower expense ratios.

Now, think about the kind of investor you are – are you the kind who isn’t planning to take out money in the near future? Did you (wisely) hold through your investment when others were panicking & selling during the market crash in Sep 2018? If so, that’s great for you – but then why should you pay for the transaction costs incurred due to the activities of other investors?

If you think that would be unfair, then ETFs are the right instrument for you.

(By Anugrah Shrivastava, Head of Investments, smallcase Technologies)

(Disclaimer: These are the views of the author. Please consult your financial advisor before making any investment)

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