It is difficult to predict the liquidity of an exchange traded fund
Every ETF appoints brokers to create liquidity in the market by standing as counter-party for whosoever wants to buy or sell ETFs
To avoid fund manager risk, or the risk of stock-picking calls going wrong by the fund manager, passive funds are a good option to get an equity exposure. There are 54 exchange-traded funds (ETFs) and 22 index funds on offer, which track various stock market indices, according to Value Research. Usually, Mint Money has told you to consider ETFs on account of their superior structure and costs, but liquidity could be a practical problem when you go to buy or sell. What is liquidity and why is it important? The basics first.
What is an ETF?
An index fund invests in all the stocks—and in the same proportion—as those in the scheme’s benchmark index. A small percentage of its corpus, up to about 5%, may be held in cash to take care of inflows and outflows. An ETF does the same, but its mechanism is different. An ETF creates units, which are then available on the stock market for sale where investors like you can buy them. Every ETF appoints market makers who are generally stock brokers with the main task of creating enough liquidity in the market by standing as counter-party for whosoever wants to buy or sell ETFs, in case enough buyers and sellers are not available.
An ETF unit is equivalent to a basket of shares in exactly the same proportion that they lie in the scheme’s benchmark index. A market maker either gives this stock basket or cash equivalent to acquire the index stock basket to the fund house in exchange of ETF units and then makes them available on the stock exchange. Unlike an index fund unit that can be bought or sold by investors of fund houses for exchange of money in any amount (also providing for fractional units), an ETF unit must be exchanged only with this basket of stocks in exactly the same proportion as they lie in the benchmark index, thereby creating fixed number of units. That is why, typically, if you want to buy or sell an ETF unit, you don’t go to the fund house. You need the stock market. Large investors, however, can go to the fund house and exchange ETF units against the basket of shares.
Measuring the impact cost
On paper, an ETF is more efficient than an index fund. General measures for liquidity, like trading volume and spread, can sometimes be deceptive. An index fund manager has to manually buy and sell shares to realign the portfolio with the benchmark index at the end of market hours every day. Although index funds are supposed to be strictly managed passively, there have been instances in the past where—on some occasions—some index funds have held more than mandated cash.
An ETF is superior as units are created only if the creation unit is of the specified size (basket of shares and a little bit of cash; all specified in the scheme’s offer document).
In reality, you could end up limiting your gains in an ETF if your ETF is not liquid enough. For instance, on 13 September, for SBI - ETF Nifty 50, the first eight (8) units were available for sale at a price of Rs102.42 each. But if you wanted to buy more, the next lot (7,483 units available at the time) were available for Rs102.59 each. Next 1,000 units were available for Rs102.64 each. Notice here how the price slowly moves up as you try to buy more units.
Take Kotak Nifty ETF’s (KNE) example. On the same day, you could sell your KNE units for Rs101.85. But you could only sell one (1) unit at this price (the highest price offer at that moment). Next 7,268 units would fetch you Rs101.83 per unit. Next one unit could fetch you Rs101.82. Next 204 units could fetch you Rs101.80 each.
Notice how the price drops as you try to liquidate more and more of your units. This is called impact cost.
Hence, in such cases, if you have to trade a decent quantity, you won’t be able to buy or sell at the best available price. The additional cost you have to incur to trade your quantity over the best available quote is termed as impact cost. Lower the impact cost, better is the liquidity of an ETF.
What to do?
What happens if you have been patiently investing in ETFs all your life and then, upon retirement, want to sell them and enjoy the money? It’s possible that if your ETF is illiquid, you might not be able to sell your units on a given day and you could get stuck. Some fund houses do help you liquidate your units if you can’t find enough sellers. For this you need to approach the fund house. The ETF segment is a growing one in India and over time its liquidity will improve as demand for such ETFs goes up. Till then, stick to index funds if you wish to avoid fund manager’s risk.