How to invest in Exchange Traded Funds (ETFs)

ETFs are nothing but open ended mutual fund schemes listed and traded on stock exchanges. The major difference between ETFs and traditional mutual funds is availability of real time net asset value (NAV) apart from cost.

There are two routes offered to investors who wish to invest in ETFs. i.e. 1) Over the cash segment of NSE/BSE & 2) directly with product manufactures i.e. AMCs.

Over the cash segment of NSE/BSE

As ETFs are listed and traded on the exchanges, it is proffered way of investing in ETFs. Investors can simply buy or sell ETFs at real-time price the way individual stocks like Reliance, Infosys etc. are bought and sold. All the rules & regulations related to settlement, delivery etc applicable to stocks are also applicable to ETFs.

To provide liquidity on the exchanges, AMCs appoints Market Makers (MMs) / Authorized Participants (APs). These APs / MMs are nothing but pre appointed stock brokers who offer buying & selling quotes on the exchanges.

APs / MMs continuously engage with respective AMCs and are able to create and redeem ETF units on real-time basis.

To put it in simple terms, it is just like wholesale & retail model. E.g. if you wish to buy small quantity of fruits or vegetables you go to local vendor available next to your home. Intern these local vendors source the fruits and vegetables from APMC market i.e. from wholesalers.

Similarly, when investors want to buy / sell ETF units in small quantity they go to APs / MMs via stock exchanges. In turn these APs / MMs source units from AMCs.

One may wonder why APs / MMs provide the liquidity on behalf of AMCs and also carry some risks. They primarily do it to make small profits. Let’s say if they buy the ETF units in bulk from AMC at Rs. 100 they will retail it to investors for Rs. 101. Similarly if investors want to sell the units, they will buy if at Rs. 99 and sell to AMCs at Rs. 100.

Directly with product manufactures i.e. AMCs

When investors want to buy or sell ETF units in bulk they can directly approach AMCs. However, all AMCs specify “Basket Size” for each of their ETFs.

Again to put it in simple words, wholesalers specify minimum order quantities (MOQ) for a particular fruit or vegetable. Similarly, AMCs also specify MOQ of an ETF commonly known as Basket Size. E.g. a single basket size of Nifty ETF can be 5,000 units (approximately Rs. 45 Lakh) or of Sensex ETF can be 10,000 units (approximately Rs. 30 Lakh)

So if investors wish to buy or sell ETF units directly with AMC, transactions has to be in multiple of basket sizes as specified by an AMC for that particular ETF. I.e. in case of Sensex ETFs transactions has to be in multiple of Rs. 30 Lakh or of Nifty ETF in multiple of Rs. 45 Lakh.

Which route to choose? Direct with AMC or Over the NSE/BSE counters.

As mentioned above investor can route the transactions directly with AMC if the investment amount is around Rs. 30 Lakh – 45 Lakh. The advantage will be the lower cost as compared to buying / selling on the exchange. The disadvantage will be processing the transactions directly with AMCs as the process is not as simple as buying / selling traditional mutual funds.

In case if investment amount is not as big as basket size, transactions can be routed on the cash segment of NSE/BSE. The advantage will be ease of transactions which can be done in multiple of as small as one unit of an ETF.  However, investors need to pay for impact cost, bid ask spread, APs margin and brokerage.

Points to be considered while buying / selling ETFs

  • Liquidity: If investor is buying / selling ETFs on NSE/BSE, check liquidity and market dept. If ETF is less liquidity impact cost increases. However, even if ETF is less liquidity, due to APs / MMs trading price will be in the range of 1% of real-time NAV. Check liquidity trend here.
  • Cost difference: As explained above due to APs / MMs providing liquidity, buying / selling ETFs on exchanges is costlier. Typical cost difference is explained below. This is just an estimation based on current market practices. There will be different cost for different ETFs. If investor has buying / selling requirements which is in multiple of Rs. 45 Lakh, it is better to directly deal with AMCs.

  • NAV vs Trading Price: NAV is the real-time portfolio value of an ETF unit. These keeps on changing with intraday market movements. Trading price is price at which ETF units are traded on the NSE/BSE. Lesser the gap between NAV and trading price better the ETF.
  • Index Tracking Ratio: Generally NAV of an ETF is priced in relation to its underlying Index. E.g. if Nifty ETF is priced at 1/10th of an Index & if Nifty value is at 8,000 points, NAV of an ETF should be around Rs. 800 per unit. However, NAV may differ due to accumulation of dividends, expenses charged to the scheme & tracking errors.