Exchange-Traded Funds: New kid on the block

Globally, Exchange-Traded Funds (ETFs) have been around for a while. Even in India, the first set of ETFs are decades old, but their relative popularity has been low, until now.

Primary causes for a jump in popularity were no different from global trends – a need for diversification from domestic markets, a move away from active managers consistently underperforming headline indices (82% of large-cap fund managers underperformed the S&P BSE100 index over the last five years as per S&P SPIVA year-end 2021 report), and rapid evolution of discount brokers and portfolio management or advisory platforms that made investing easier and cheaper.

Not just that, the tools available to individual investors for managing investments too skyrocketed as have the knowledge levels of advisors (however small their numbers are now), as a simple-to-understand, powerful, diversified investment. Simply speaking, an ETF is a basket of shares, bonds, commodities, or other investments where units of these baskets (or funds) are traded on stock exchanges hence the name Exchange-Traded Fund.

Ease of using ETFs too is a significant factor for asset allocation. It allows for single, low-ticket (as small as Rs 20-30 in some cases) transactions making them ideal democratic products for large pension funds such as EPFO and individual investors.

For ETFs, a stock exchange allows investors to target a certain price, unlike traditional mutual funds which have entry/exit blind pricing i.e., one does not know at what price they are buying or selling a fund. Further, there are no loads or entry/exit restrictions and managing fees tend to be lower for ETFs (NiftyBeeS runs at ~0.06% expense ratio).

Lower risk comes in tandem with low expenses as the churn (different companies entering or exiting the underlying index) is quite low as there is no expectation to outperform the reference indices.

The rub is buying and selling ETFs, like shares, is not without complications. While the process is simple enough, one should be aware of certain information like iNAV (intraday Net Asset Value), premium discount and price dislocations, if any. The price of an ETF depends on demand and supply as well as the NAV of the basket. When the demand is more, the ETF trades at a premium: similarly, a surplus supply can result in a discount.

Exchange Traded Fund’s indicative NAV (iNAV –10 sec to 30 min snapshot net asset value of the ETF) is continuously calculated and published by fund managers in India.

While the iNAV reflects the value of the constituent stock, the price of the ETF unit reflects the market’s interest based on the participant’s view of the underlying basket, providing transparency, intra-day liquidity and thereby better price discovery.

For example, the difference between the NAV and the traded price may present an arbitrage opportunity which could lead to the creation of units or redemption of existing units.

The iNAV conundrum becomes more interesting when the ETF portfolio constituents do not trade during Indian market hours (NASDAQ100 - MON100 ETF) or trade round the clock (Gold or Silver ETF). Traders use strategies which do not rely on AMC published iNAVs and instead look at those global markets like CME Globex to determine the value of the ETF. For example, it is better to use Nasdaq 100 e-Mini futures rather than the iNAV.

However, all these calculations and complications may not be everyone’s cup of tea. Two choices therefore can be a) use Index funds instead of ETFs which are easy to buy/sell albeit a little expensive or b) create a self-rebalancing portfolio using market trades on platforms like Wealthdesk. Such ETF based core portfolios are inexpensive, bespoke, and suitable for most financial goals an investor may have.

(The author is partner, Infinity Alternatives)

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