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.
“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.
