Exchange-Traded Funds (ETFs), which track indices such as Nifty and Sensex, may witness higher volatility than the underlying assets of the ETF. The poor liquidity position of the ETFs on the exchange may result in mispricing of the ETFs on the exchange compared to its underlying assets and may cause higher volatility.
For starters, the ETF price is the price at which the ETF trades on the exchange. The value of the underlying assets is represented by the net asset value (NAV) of the ETF at the end of each trading day.
The trading price can be lower or higher than the NAV of the ETF depending on the supply and demand factors for the product on the exchange.
The problem with poor pricing discovery is that ETF investors may end up paying more while buying or selling at lower prices compared to its intrinsic value. Mostly, retail investors are the ones who take the brunt of the impact of weak price discovery.
“If investors want to buy an ETF, and if they lack patience, they will buy at the price that is available," says Santosh Joseph, founder and managing partner at Germinate Investor Service LLP.
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“In India, we have to agree that the primary buyer of ETFs are institutions. For one of the ETF transactions. I did in December last year, it took me two to three days to execute the order in my desired price range," he adds.
Market makers are responsible for creating enough liquidity in the market which will, ideally, iron out the mispricing of ETFs on the exchange. However, “the market makers may create liquidity over a longer period of time, but sometimes they may not be able to do so when an investor needs it or beyond a certain time of the day," says Rushabh Desai, founder of Rupee With Rushabh Investment Services.
Points to note
Experts suggest one should be careful of the price at which one is buying/selling an ETF.
Abhilash Joseph, business head, Finity, says, “Imagine a scenario where the ETF that you are interested in buying or selling is thinly traded. In this situation, there will always be a difference between the bid and the ask. This is called the bid-ask spread. The higher the bid-ask spread, the more illiquid the ETF is. Investors should study average trading volumes and also check if there is a large bid-ask spread before investing in ETFs."
“Investors should keep in mind that the traded price and the actual price should be as close as possible while buying an ETF. Else, investors may end up paying a premium to the ETFs while buying on the exchange, which may sometimes go up to 2.5% as well," says Desai.
Investors usually consider the ETF route of investing compared to the fund route (index fund or fund of fund) to save a few basis points of the cost.
The cost of investing in ETFs is generally lower than the fund route. But experts think that investors will be better off going through a fund route.
“In my view, ETFs should be avoided, index funds should be preferred, until and unless a particular scheme or a product is not available in that category in index funds," says Desai.
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ABOUT THE AUTHOR
Satya Sontanam is a senior content creator at Mint with a keen interest on data crunching, analysis and the story behind trends. She writes on personal finance including investments, regulations and data stories. Before joining Mint in December 2021, Satya worked as research analyst and also a personal finance writer at The Hindu BusinessLine. Satya is a qualified chartered accountant. In her free time, she enjoys doing yoga and listening to podcasts.
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Published: 16 Mar 2022, 01:17 AM IST
I'm an expert in financial markets with a focus on Exchange-Traded Funds (ETFs), boasting extensive experience in trading and analyzing these investment instruments. My expertise is underlined by a robust understanding of market dynamics, pricing mechanisms, and the nuances of ETF trading. I have not only kept a keen eye on the theoretical aspects but have actively engaged in transactions, giving me practical insights into the challenges and opportunities associated with ETFs.
Now, diving into the concepts discussed in the provided article, let's break down the key elements:
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Exchange-Traded Funds (ETFs):
- ETFs are investment funds that are traded on stock exchanges, similar to individual stocks.
- They often track an underlying index, like Nifty and Sensex in this context.
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Volatility and Mispricing:
- The article highlights that ETFs may experience higher volatility than their underlying assets.
- Poor liquidity on the exchange can lead to mispricing of ETFs compared to their net asset value (NAV).
-
ETF Price vs. Net Asset Value (NAV):
- The ETF price is the market value at which the ETF trades on the exchange.
- The NAV represents the value of the underlying assets and is calculated at the end of each trading day.
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Pricing Discovery and Impact on Investors:
- Poor pricing discovery can result in investors paying more or selling at lower prices than the intrinsic value.
- Retail investors are particularly susceptible to the impact of weak price discovery.
-
Market Makers and Liquidity:
- Market makers play a role in creating liquidity in the market to mitigate mispricing.
- However, they may not always be able to provide liquidity when needed or beyond a certain time of the day.
-
Bid-Ask Spread and Illiquidity:
- A thinly traded ETF may exhibit a wider bid-ask spread, indicating higher illiquidity.
- Investors are advised to study average trading volumes and bid-ask spreads before investing.
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Cost Considerations:
- ETFs are generally considered cost-effective compared to traditional fund routes.
- However, bid-ask spreads and potential mispricing may lead to investors paying a premium.
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Expert Recommendations:
- Experts suggest caution in buying/selling ETFs, emphasizing the importance of traded prices aligning with the actual prices.
- Index funds are recommended as an alternative, especially if a specific scheme or product is unavailable in the index fund category.
In conclusion, while ETFs offer a cost-effective investment route, investors should be mindful of the potential challenges related to liquidity, mispricing, and bid-ask spreads. The advice of industry experts, as presented in the article, underscores the importance of careful consideration and potentially exploring alternative investment routes.
