Exchange-traded funds (ETFs) have become a pivotal instrument for passive investing, providing investors with a wide spectrum of investment avenues across diverse asset-classes, sectors and strategies. With over 206 listed ETFs spanning equity, debt and commodities like gold and silver, collectively managing assets worth ₹7.15-lakh crore as of April 2024, investors have access to a dynamic toolkit for constructing portfolios tailored to their risk appetites and financial objectives. However, navigating the intricacies of ETF-investing involves understanding the disparity between an ETF’s market price and its Net Asset Value (NAV), and understanding key performance metrics crucial for effective selection. Mastering these concepts is essential for investors to wield ETFs effectively, enabling them to make informed decisions and optimise their investment strategies.

Market price vs NAV

The NAV of an ETF represents the per-share value of the fund’s underlying assets after deducting its liabilities and is typically calculated at the end of each trading day. On the other hand, the market price of an ETF fluctuates throughout the trading day based on supply and demand dynamics. When demand for an ETF rises, its market price may surpass its NAV, leading to a premium. Conversely, if demand declines, the market price might drop below NAV, resulting in a discount. Timing differences, particularly evident in international ETFs, can also contribute to premiums/discounts. This occurs when there’s a gap between the ETF’s trading time and that of the underlying securities in foreign markets. Recently, international ETFs have been trading at a premium, as SEBI instructed AMFI to halt new investments from April 1 due to robust inflows nearing the $1-billion investment cap. Factors such as asset base and trading volumes further influence the extent of these deviations, with more liquid ETFs typically experiencing smaller premiums or discounts.

To address these discrepancies, mechanisms such as creation/redemption processes come into play. In a circular dated May 23, 2022, SEBI mandated fund houses to appoint at least two market makers (also known as Authorised Participants) for each ETF to ensure continuous liquidity. These market makers exploit price differences by buying ETF shares at a discount or creating new shares when prices are at a premium. Additionally, investors can directly route ETF unit trades through fund houses for transactions exceeding ₹25 crore, eliminating concerns about premiums or discounts. However, despite these measures, disparities may still persist due to challenges like accessing underlying securities or delays in processing international holdings. Hence, investors should exercise caution when trading ETFs, using limit orders near NAV to manage risks associated with premiums or discounts. Additionally, investors can monitor the ETF’s true value through the indicative NAV (iNAV), disclosed by fund houses in real time with minimal delays, enabling continuous assessment of market price-NAV differences.

Performance metrics

Tracking difference (TD) and tracking error (TE) serve as vital metrics for assessing the performance of passive funds, including ETFs, in comparison to their underlying benchmarks.

TD focuses on the disparity in total returns between the ETF and its benchmark over a specific timeframe. It provides insights into how effectively the fund replicates the index’s performance. On the other hand, TE gauges the consistency of the fund’s performance relative to its target index, quantified as the annualised standard deviation (SD) of the TD for a designated period. These deviations can arise due to factors such as administrative and management expenses, rebalancing and liquidity issues. A lower TE signifies a closer alignment between the ETF and the index, while a higher TE indicates greater deviation. Investors can typically access TE details in the mutual fund factsheet. Moreover, SEBI has mandated all fund houses to disclose past one-year TE data on a rolling basis on their respective websites and AMFI platforms, along with imposing a limit on TE, which should not exceed 2 per cent.

In conclusion, investors should prioritise ETFs with smaller premiums/discounts and lower TE, alongside considering lower expense ratios and larger asset sizes. Retail investors should consider ETFs with larger asset sizes for increased liquidity and reduced impact costs. Investors can build diversified portfolios aligned with their long-term goals by weighing these metrics alongside their investment objectives.