CEO and Managing Director
Motilal Oswal Asset Management Company
Since the 1995 launch of the first ETF based on the S&P 500 Index, ETF units are innovations which account for a large chunk of volumes in global stock markets. ETFs may represent a basket of stocks which replicate or enhance an index such as the CNX Midcap or the Nasdaq-100 Index. Along with diversification benefits at low cost, ETFs may offer trading flexibility of a stock (short selling, buying on margin and purchasing single units). So any investor or trader may trade an index (or other ETF) irrespective of the size of their position or the value of their individual trade.
Additionally, all ETFs offer a significant diversification benefit. Firstly it allows the investors to invest in multiple markets or market segments without incurring the cost of replicating stock / bond portfolio. Within the portfolio, numerous stocks tend to be not perfectly correlated. Hence, the volatility of an ETF with a significant number of constituents will be lower.
A Mutual Fund: Like a mutual fund, all ETFs are open ended funds, which continuously issue/redeem units and declare a Net Asset Value (NAV) of the underlying portfolio on a periodic basis. And like a mutual fund, an ETF is managed by an Asset Management Company whose activities have the fund’s trustee’s oversight as well as supervision by the stock market regulators.
A Share: But an ETF is exactly like a share on the stock exchange. Market entities are buyers, sellers and there are intermediaries (brokers) and an exchange where the trades take place. Unlike a share, however, fresh tradable shares of the ETF (units) can be continuously created (or redeemed) on-demand (subject to minimum volumes), which ensures that the premiums or discounts to the price are a temporary phenomenon.
Advantage ETF: ETFs indicative NAV (i-NAV) is continuously calculated and published. While i-NAV is a reflection of the value of the underlying stock, the price of the ETF unit reflects market’s interest based on the participant’s view of the underlying basket, providing transparency, intra-day liquidity and thereby better price discovery. For investors, this allows them to trade and monitor their portfolio in real time and take corrective measures should their risk appetite change.
Investing in an ETF, unlike a share, provides liquidity by secondary market trading as well as through the unit creation/redemption process. The former is measured by trading volumes and the latter is virtually unlimited for creation and limited to the AUM for redemption. All these activities have the effect of matching demand and supply thereby catering to all sizes of investor orders. Trading volumes therefore have little bearing on the liquidity of an ETF.