How ETF Works?

Introduction

An exchange-traded fund (ETF) is a type of security that tracks an index, sector, commodity, or another asset, but which can be purchased or sold on a stock exchange the same as a regular stock. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. Unlike mutual funds, the price of an ETF’s shares will change throughout the trading day as the shares are bought and sold on the market.

Difference between ETFs, Stocks & Mutual Funds (MFs):

• The ETFs and Stocks have Real-Time Pricing in the market whereas, in MFs, the prices change only in a day.
• Both in ETFs and Stocks, a person can put a limit price order, whereas MFs can only be bought on current NAV.
• Both the ETFs and Stocks can be traded online through exchanges like NSE/BSE, whereas, MFs cannot be traded in exchange.
• If we buy only a single unit in stock, we cannot diversify our portfolio but a single unit of ETF or MF consists of various shares which provides diversification benefits.
• In an ETF, the returns are at par with the performance of the market or index whereas, in stocks and MFs the returns depend on the performance of underlying stocks.
• Both in ETFs and Stocks, there is no such thing as exit load but in MFs exit load is charged at the time of withdrawal before the lock-in period.

Both in ETFs and Stocks a person can make a profit from availing arbitrage opportunities, but not in the case of MFs

How ETF Works?

• There are 2 types of liquidities when it comes to ETFs, the first is the liquidity of the underlying assets in the index and the second is the tradable liquidity between investors.
• For example, a fund house started Nifty 50 ETF with 100 units in which: Investor 1 bought 70 units Investor 2 bought 20 units and Investor 3 bought 10 units.
• If Investor 3 wants to sell his 10 units, he can only sell to Investor 1 or 2 and it depends on their willingness to buy at a particular time.
• The market makers are present to create liquidity among the investors but they won’t help every time to create liquidity.
• But if Investor 1 wants to sell his 70 units, he can directly sell to the fund house as the number of units is more.
• The fund house can create additional units following the demand from the running markets.

What is an ETF’s Market price and NAV?

• The ETF market price is the price at which an ETF can be bought or sold on the exchanges during trading hours. If more buyers than sellers arise, the price will rise in the market, and the price will decline if more sellers appear.
• The net asset value (NAV) of an ETF represents the value of each share of the fund’s underlying assets and cash at the end of the trading day.
• An ETF is said to trade at a premium when its price exceeds its NAV. An ETF is said to trade at a discount when its price is below its NAV.
• Higher demand will move the price up and higher supply will drag down the ETF prices in the market.

What is INAV?

• INAV provides an Intraday Indicative Net Asset Value of an ETF based on the market values of its underlying constituents.
• INAV is reported approximately every 10-15 seconds late, hence it represents a nearly real-time view of the value of a fund.
• It can be found on every mutual fund website easily.
• INAV is a tool that helps to keep funds trading near their par value.
• Reporting an INAV can help a fund to avoid significant premium and discount trading.

It is not advised to buy an ETF above the price of INAV because that way you will be going to pay a premium to buy. There can be a mismatch in the current prices and the actual INAV in the ETFs with very low volumes.

For understanding that we’ll take an example of an ETF Fund:

MIRAE ASSET NYSE FANG+ ETF:

What is FANG+ ETF?

• The NYSE FANG+ index is an equal dollar weighted index that consists of 10 stocks across technology, media & communications, and consumer discretionary sectors. NYSE FANG+ Index constitutes 10 stocks – Alibaba, Facebook, Alphabet, Apple, Baidu, Nvidia, Amazon, Netflix, Twitter, and Tesla.
• When the fund is launched in India, it created a huge demand and the supply was limited. As we can see in the chart, even though the underlying index did not show proportional improvement, MIRAE ASSET NYSE FANG+ ETF hit the upper circuit on 14^th May 2021.
• Many investors bought the ETF units at a very high premium which was not in line with INAV and faced losses of up to 20%.

ETF performance over the years:

• The average daily turnover of the ETFs in India is continuously rising from CY 2015 to CY 2020.
• The investors traded in these funds are also increasing year on year from CY 2015 to CY 2020.
• So one can buy the fund and expect that the volumes will increase in the future and liquidity will arise.
• Performance of the ETFs between CY15 to CY20 is attached below:

ETF comparison:

• Here we can see that the SBI – ETF Nifty 50 has the highest Assets under Management with over Rs. 92,966 Cr.
• The liquidity is also highest in SBI – ETF Nifty 50 with a minimum of 63,671 shares traded daily and the maximum goes up to 399,075 shares.
• With an average volume of 164,465 shares, SBI – ETF Nifty 50 ensures that the price of the ETF will be close to the INAV.
• Whereas in the case of LIC MF ETF Nifty 50, one can see that the volumes are pretty low which can be an alarming signal for the investors.

Things to keep in mind when investing in ETF:

• INAV

The INAV represents the “fair” price of an ETF, so paying substantially more (premium) or receiving substantially less (discount) than INAV is generally ill-advised.

• How high is the tracking error? 

 Tracking error is the difference between the returns of the fund and the benchmark index it is trying to mimic. A higher tracking error shows that the fund is not replicating the index truly.

• How liquid is the fund?

Liquidity can be an issue in the case of ETFs as they can only be bought and sold on the exchanges you would be able to sell only if there is enough demand and that may not always be the case.

• Expense Ratio?

The expense ratio should also be checked before choosing a fund. The higher the expense ratio lesser will be the in hand profit for the investor.