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Understanding Exchange Traded Funds (ETFs) – Part 1/2

With awareness about the financial assets increasing slowly and steadily in India, the concept of Exchange Traded Funds (ETFs) is also trying to get its foothold. We can say the ETF market in India is at a nascent stage and a good traction was witnessed in the last one year. The National Stock Exchange (NSE) data suggested that - ETFs saw transactions by 32.2 lakh investors in the CY20 (Calendar Year 2020), showing a jump of 200 per cent over CY19 the ETF investments are maintaining the growth trend for the past 5 consecutive years. Further the average daily turnover at Rs. 241 crore also increased by 15 per cent in CY20 over CY19.

ETFs in India have been there for a while, however, the popularity amongst the retail investors has not been seen. It is either high net-worth individuals (HNIs) or the large institutional players forming a major part of this investment vehicle. While the ETF market might have seen a good growth over the years it is mainly on account of Employees Provident Fund Organisation (EPFO) investing in Nifty ETF and Government focusing on its divestment target form through the Central Public Sector Enterprise ETFs and Bharat 22 ETF. Further, the asset management companies also hardly push this being a relatively low margin product. However, slowly the retail participation is expected to increase and hence here we are explaining the concept of ETF in India.

What is an ETF?

An ETF is like a mutual fund that holds the basket of securities. However, this is the only similarity in the mutual funds and ETFs. The most important characteristic that differentiates is, unlike a mutual fund an ETF trades throughout the trading hours on the stock exchanges. One can buy and sell an ETF anytime they want similarly the way stocks are traded.

Differentiating factors

The ETF framework

When one buys a mutual fund, the simple transaction is like - the AMC takes money from the buyer and then it is invested in respective scheme asset class or securities. Then based on the net asset value (NAV) is disclosed to the buyers at the end of the day. Similarly, in case of redemption of mutual funds as well, the AMC sells the held securities and returns the money to the investor. However, there is some amount of complexity when we buy an ETF. As we stated earlier, the buyers don’t really interact with the AMC as most of the buying and selling happens on the stock exchanges. Similarly, for an ETF, it is just an exchange of units between buyers and sellers on a stock exchange. However, there are few mechanisms one needs to understand when the AMC is also involved in the transactions.

Creation and redemption mechanism

While the column heading starts with creations and redemption mechanisms there are few terms one needs to understand. The various terms like NAV, iNAV (indicative or intraday net asset value), market makers and authorised participants.

While investing in any mutual fund one looks at the NAV. For ETFs, the investors look at the ETF market price. ETF prices are determined by the demand, supply and the trading activity in the ETFs on the exchanges. And to understand the market price concept one needs to understand the ETF iNAV.

Given that ETFs trade real-time, one needs a reference point to see if the market price the buyer is looking at a trading platform is a fair one. And here the indicative or intraday NAV (iNAV) serves as that reference. The usual practice is, AMCs 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 / Divided by total ETF shares in the creation basket.

Now we will come to the factor called unit creation mechanism. One way of buying an ETF is on the stock exchanges and the other is to buy units directly from the AMC. However, this comes with some conditions. The condition is, one cannot buy just 1 or 2 units directly from the AMC. One needs to create and redeem units in what’s called the creation size that the AMC defines. A creation of a unit is a representative basket of all the securities in the same proportion as the underlying index one selects for investment. It requires Rs. 78-79 lakh for creating one unit of ETF (considering the 50,000 units and multiples). With such a higher investment amount only HNIs and institutional players dominate the volumes in the ETF. As volumes are lower this brings us to the other concept market makers and APs.

Market makers and authorised participants (APs)

The role of market makers and APs is to provide liquidity on the stock exchanges. Since an ETF trades real-time on the stock exchange, market makers are appointed by the AMCs to provide liquidity continuously. They do this by providing continuous two-way quotes on the exchange. They buy at the bid and sell at the offer and the difference is the profit they make. One may wonder why the market makers work at such a smaller amount. Remember, though these are small amounts, since they keep doing this, it tends to add up eventually.

While these are the basic concepts about ETF, in the second part of this blog we would discuss the analysis part of ETFs.

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