ETFs have already taken the world by storm & are now also seeing increased adoption in India as investors learn of its various advantages – like lower costs, increased transparency, ability to transact anytime like stocks, etc. Still, many Indian investors have thus far stayed away from investing in ETFs as they believe ETF liquidity is a concern, i.e. ETFs are illiquid. There aren’t enough people trading ETF units. As a result, investors have to pay more than the NAV (i.e. higher bid/ask spread) in order to trade ETFs.

“Liquidity is one of the critical parameters while selecting an ETF as it impacts the overall cost of ownership for investors”, says Sharwan Goyal, who is the fund manager of 4 ETFs at UTI Mutual Fund, one of the largest Asset Management Companies (AMCs) in India.

This a known market risk when trading large positions of any stock. If the stock doesn’t have enough sellers, the price and cost end up increasing due to the lack of sellers.

But unlike stocks, liquidity in ETFs can easily be created by special market-makers called Authorised Participants (APs). They are pre-appointed by AMCs to provide ETF liquidity on exchanges. In theory, this makes an ETF practically as liquid as the underlying stocks it invests in. Let’s understand how.

How is ETF Liquidity created?

Mutual funds have a subscription/redemption process that usually takes 1-2 days, where the particular AMC issues/redeems units to investors. While AMCs also issue ETF units that have a NAV, these units can be bought & sold instantly over an exchange, thus providing instant liquidity.

The reason ETFs can provide this liquidity is because of something known as the “creation/redemption” process of ETF units, which involves third-parties called Authorised Participants (APs).

When an AMC wants to create new ETF units, whether it’s for a New Fund Offering (NFO) or to meet the increasing demand for an existing fund, it turns to these third-party APs. They can be a brokerage (like Edelweiss Securities Ltd.), specialist capital-markets firms (like Parwati Capital Market Pvt. Ltd.) or other large financial institutions that have significant buying power in the opinion of the AMC.

The AP acquires the stocks/securities the ETF wants to hold. For example, when an ETF that tracks the Nifty-50 or BSE-100 wants additional ETF units due to increased demand, the AP will buy the underlying shares of the respective indices in the exact weightage as they are in that index. The AP will deliver these shares to the AMC who maintains the particular ETF, and in exchange receive a block of ETF units of the same value.

The price of the ETF units handed to APs is based on the NAV – and not the market value at which the ETF happens to be trading. But the AP gets to sell these units in the open market, thus earning a spread (the price in excess of NAV).

Both the AMCs and the APs benefit from the transaction: the AMC receives the stocks it needs to keep their ETF in-line with the index/strategy, and the AP receives ETF units to resell for a spread & earn profits.

This process also works in reverse, i.e. when the AMC wants to redeem units or when there are more sellers than buyers. In this case:

1. The AP buys ETF units from the market in large blocks, usually costing below the market price
2. The AMC gets delivery of these blocks for redemption.
3. In return, the AP gets the underlying shares/securities of the same value
4. The AP then sells these units in the open market to earn a premium

Is ETF liquidity still a concern?

Liquidity was definitely a concern in the nascent stages of the ETF market in the early 2000s. However, the ETF market has become much larger in recent years. “We have observed improvement in liquidity of ETFs based on board market indices. Overall monthly turnover of all ETFs products was over ₹4,900 crore in May 2019 as compared to approx. ₹1400 crore in April 2012”, adds Sharwan Goyal of UTI. “However, it is still low as compared to global peers”, he further notes.

What should retail investors do?

ETFs have seen phenomenal adoption in recent years – including from the Government and the Employees’ Provident Fund Organisation (EPFO). This trend is likely to continue due to the numerous advantages of ETFs over mutual funds. This will continue to improve ETF liquidity even more.

But here’s the awesome twist – even if bid/ask spreads are slightly higher than the NAV when you have to transact, remember that you only pay that if/when you transact. If that is not too frequent, think of all the money you will save in lower expense ratios.

In fact, it’s this creation/redemption process by Authorised Participants & buying/selling of ETF units on exchanges that makes ETFs inherently fairer for long-term/buy-and-hold investors. Read more about this in our next post on the ETF Education series.

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This post is the 2nd one in the ETF Education Series. If you are new to ETFs or interested to learn more about them, we recommend reading the entire series:

1. ETF 101 – What is an ETF?
2. ETF Liquidity, Creation, and The Role of Authorised Participants
3. 3 Stock Market Crashes that changed Investing: Origins of MFs & ETF
4. ETFs – Growth & Scope in India