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Why you should keep an eye on

liquidity, price deviation and
tracking error while investing in
ETFs
Exchange Traded Funds are superior in structure as they can
mimic their benchmark indices more closely than the other
passive variants -index funds. With more than 200 ETFs
available in the market, it is important for investors to choose
the right ETFs for their portfolio to achieve their financial goals
DHURAIVEL GUNASEKARAN

JUNE 10, 2024 / 0 2 : 3 3 P M I S T

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ETFs can be used for an effective asset allocation strategy

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An extreme volatility in the stock market on June 4, the day of election results, caused huge
deviation in the traded price of many Exchange Traded Funds (ETFs) against their real time
indicative NAVs.

Such deviation of market price i.e, premium or discount to their indicative NAVs occurs either
when the markets are at utmost volatility or in thinly traded ETFs or less-active market makers.
This could result in investors incurring losses if they buy the units with the price premium to
their indicative NAVs.

ETFs and index funds are passively managed mutual fund schemes different from the
schemes that are actively managed by fund managers. These schemes do not try to beat but
just try to replicate the performance of the underlying benchmark. Hence, they do not require a
high level of intervention from fund managers. They just imitate the portfolio of an index, say
Nifty 50, by investing in stocks that are a part of the index in the same proportion as in the
index.
The big benefit of an ETF over an index fund is its superior structure. An ETF can much closely
mimic its benchmark index than an index fund because of the way an ETF is ‘created’. They are
traded in the cash segment of the BSE and the NSE like any other equity shares. Through
demat accounts, investors can buy and sell ETF units at the prevailing market prices on BSE
and NSE during market hours. ETFs can be part of one’s portfolio and used for an effective
asset allocation strategy.

Currently, there are more than 200 ETFs being traded in the stock markets. It is important for
the investors to choose the right ETFs for their portfolio wisely to achieve their financial goals.
Here we explain six key aspects that investors have to consider while buying ETFs from the
secondary markets.

Premiums and discounts of spot price to the indicative NAV

During trading hours, the spot price of the ETFs may trade at a premium or discount to their
iNAVs (indicative NAVs). This occurs due to extreme volatility in the market movement,
illiquidity and less-active market makers.

Chintan Haria, Principal Investment Strategy, ICICI Prudential AMC says, “ETFs generally trade
close to its iNAV, which is the fair value of an ETF’s underlying. Any premium/discount to iNAV
tends to be short lived and corrects as market makers are appointed for each ETFs to ensure
that trade happens at fair value”. Market makers are authorised participants or arbitrageurs
appointed by the AMCs to keep the spot price close to the fair value.
iNAV provides an intraday indicative value of an ETF based on the market values of its
underlying constituents. The value is calculated and then disseminated to the public every 15
seconds for equity ETFs (at least four times in a day is for debt ETFs). They are displayed in
the mutual funds’ websites on a real-time basis.

If the price of the ETF trades above its iNAV, the ETF is said to be trading at a ‘premium’ and if
the price is below its iNAV, it is said to be trading at a ‘discount.’ This leads to higher impact
cost. An ETF with the market price having lower premiums and discounts to its iNAV is
preferable.
Historical data calculated from the close price and NAV of the ETF will give you an idea about
the past trend. The premium or discount data compiled over the last one year shows that the
market prices of ETFs, including Nippon India Nifty BeES, SBI Nifty 50 ETF and ICICI Pru Nifty
50 ETF have relatively lower premiums and discounts to their respective NAVs.

Choose the right indices that suit your risk profile

Mutual fund companies offer a wide choice of ETFs based on the broader equity indices,
sector, thematic, and smart beta ETFs. On the fixed-income side, liquid, corporate bond and gilt
ETFs are also part of the offerings.

They can be part of the asset allocation strategy in one’s portfolio and pick the ETFs based on
the risk profile and financial goals.

For instance, investors who are new to equity markets wanting to taste equity risk can
accumulate the units of the ETFs tracking broader market indices like Sensex, Nifty 50 and
Nifty 500 index. ETFs tracking mid-cap and small-cap indices can be a good bet for investors
with high risk appetite.

Read here: Mid-cap and Small-cap Funds: How can retail investors get the best out of
them?
Eye on the liquidity
Liquidity, or the trading volume plays an important part in your ETF selection. Since you buy
and sell on the stock exchange, the key requirement is that there should be ample sellers and
buyers available when you want to buy and sell units and you are able to get a good price.

In India, many ETFs are traded with thin liquidity. It is better to choose ETFs that are traded
every day with decent volumes. You should strictly avoid the ETFs that are thinly traded.
Tracking error and tracking difference matter
Tracking Error (TE) and Tracking Difference (TD) are the two parameters used to gauge the
performance of the ETFs, as they are meant to track closely the performance of their underlying
indices. Sometimes, the returns generated by the ETFs deviate from the returns of their
respective benchmarks which is called tracking difference.

Apart from the return differences, the efficacy of ETFs is also measured through the TE, which
is the statistical tool using the standard deviation to measure the deviation between the ETF’s
performance and that of its benchmark.

ETFs with lower TE and TD are preferred. TE and TD may rise mainly due to the cash holding,
expense ratio and lag time to rebalance the constituents in line with the index.

Check the expense ratio

Passive funds are known for their lower expense ratio as they exclude the fund management
charges because fund managers’ contribution is almost nil.

ETFs are cost-effective as they levy relatively lower fees compared to the regular and direct
plans of the actively-managed equity funds and index funds.

Pick the ETFs with lower expense ratio within the category.
Look for ETFs with lower impact cost
The impact cost is an indirect transaction cost incurred due to higher bid-ask spread. The
impact cost in an ETF would be lower if there is higher liquidity in the exchange.

When executing buy orders, you may not get the desired price due to lack of sellers at the
terminal, which may result in you paying a higher buying price than the desired price. This will
increase your purchase cost.

Impact cost data is available on the BSE and the NSE websites. ETFs with lower impact cost
are preferred.
The choice of ETFs has increased in India over the last few years. Currently, they are available
across asset classes, including equity, debt and gold. However, participation from retail
investors is still at the nascent stage. Liquidity, TE, TD, expense ratio, impact cost and premium
or discount of the spot price to its NAV determine the suitability of the ETF to your portfolio.