Exchange-traded funds (ETFs) have emerged as a key avenue for passive investing, offering investors with a diversified range of investment opportunities across asset classes and sectors. As of April 2024, there were approximately 206 listed exchange-traded funds (ETFs) covering debt, equities, and commodities such as gold and silver. These ETFs together manage assets valued at Rs. 7.15 lakh crore. This gives investors a flexible toolset to build portfolios that suit their risk tolerance and financial goals. Before investing in an ETF, investors have to first understand the difference between the ETF’s market price and Net Asset Value (NAV).
Let’s try to figure out the difference between an ETF’s NAV and its market price. The NAV of an ETF is the per-share value of the fund’s underlying assets after subtracting the liabilities it carries, and it is computed at the conclusion of each trading day. On the other side, the market price of an ETF varies during the trading day due to the dynamics of supply and demand. When demand for an ETF increases, the market price may exceed the NAV, resulting in a premium. If demand drops, the market price may fall below NAV, which creates a discount. Premiums/discounts can also be influenced by timing discrepancies, which are especially evident in international ETFs. This occurs when the ETF’s trading time differs from that of the underlying assets in overseas marketplaces. Asset base and the volume of trading can impact the magnitude of these variations, with highly liquid ETFs having lower premiums or discounts.
To fix these inequalities, practices such as creation/redemption mechanisms are employed by the market regulator. In 2022, SEBI recommended that fund houses nominate at least two market makers (also known as Authorised Participants) for each ETF to maintain ongoing liquidity. These market makers capitalize on price disparities by purchasing ETF shares at discounted prices or issuing new units when prices are at a premium. Regardless of these safety measures, inequalities can stay owing to issues such as getting underlying assets or handling overseas holdings. Hence, investors ought to apply caution while trading in ETFs, and be aware of the risks involved with premiums or discounts.
Investors should also be aware of other performance gauges, such as Tracking Difference (TD) and Tracking Error (TE). These are critical criteria for evaluating the efficiency of passive funds, particularly ETFs, in relation to their underlying benchmarks.
TD looks at the difference in total returns between the ETF and its benchmark over a certain time period. It gives information on how well the fund mirrors the index’s performance.
Conversely, TE measures how consistently the fund performs in comparison to its target index, which is expressed as the TD’s annualized standard deviation (SD) over a certain time period. Administrative and managerial costs, rebalancing, and liquidity concerns are all potential causes of these variances.
A lower TE suggests a stronger correlation between the ETF with the index, whereas a larger TE indicates greater dispersion. Investors may often find TE information in the mutual fund datasheet. Furthermore, SEBI has ordered that all fund companies report the prior one-year TE figures on a rolling basis on their respective websites and also in the AMFI platforms. Also, fund houses should mandatorily impose a TE restriction of no more than 2%.
Investors should search for ETFs with lesser premiums/discounts and lower TE, as well as lower expense ratios. Retail investors could also look into ETFs with larger asset under management (AUM) levels for better liquidity.
