Opt for exchange-traded funds with low-impact cost, say analysts

To avoid the challenge of buying ETFs at the right price, choose index funds

Highlighting the issue of low liquidity in exchange-traded funds (ETFs), the Securities and Exchange Board of India (Sebi) Chairman Ajay Tyagi said recently that the regulator will examine ways to deal with this problem. Until the regulator acts, investors must tackle this issue themselves.

How low liquidity can hurt  

While a large number of ETFs has been launched, only a small percentage is liquid. Investors who enter into one without checking its liquidity risk burning their fingers. Suppose the net asset value (NAV) of an ETF is Rs 100. When you try to buy it, you get a price of Rs 102. When you sell it, you get a price of Rs 98. A considerable portion of the returns earned from such an ETF will get wiped out by the large bid-ask spread.   

The nature of the underlying stocks affects an ETF’s liquidity.

“If the constituent stocks are liquid, the market maker’s task becomes easier. By trading with the fund house in ETF units and the underlying stocks, he can narrow the gap between the NAV and market price. But if the underlying stocks are illiquid, his task becomes harder,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Sebi-registered investment advisor.

What Sebi can do

Sebi could apply pressure on fund houses to appoint market makers and incentivise them to do their job. It could possibly stipulate a range, beyond which a bid or ask price shouldn’t deviate from the NAV.

Look for ETFs with low-impact cost  

Investors who don’t want all this complexity may avoid ETFs.

“If you are not able to decide whether the current bid-offer spread available on an ETF is reasonable, go for index funds,” says Anil Ghelani, head of passive investments, DSP Investment Managers.

One issue such investors could face is that there may not be an index fund for every ETF available, although this option should be available in the major categories. If you understand the issues outlined above, identify the most liquid ETF in the category you wish to invest in.

“The ETF should have a transaction volume of at least Rs 1 crore on every single day of the previous month,” says Avinash Luthria, a Sebi-registered investment advisor and founder, Fiduciaries.

Alternatively, he suggests looking for the ETF with the lowest impact cost (visit the NSE website, enter the name of the ETF, scroll down to 'trade information'). For choosing an ETF from a category (equity or gold), Luthria suggests giving 80-90 per cent weight to the impact cost and 10-20 per cent to the expense ratio.

Place limit order

When buying or selling an ETF on the exchange, select a price that is close to the NAV. “Place a limit order and not a market order,” says Raghaw. This will ensure your order gets triggered at the price you set.

Another option is to invest in a fund of fund (FoF). “If the ETF is illiquid, the fund management team will also face the same problem. Since they are professionals, they are likely to execute trades at better prices,” says Luthria.

Cost, however, could be an issue — you pay an expense ratio on the ETF and the one on the FoF. This option is especially advisable if the cumulative expense ratio is low.

Target maturity debt funds are being launched in the ETF format. Some don’t have the FoF option. High-impact cost can be ruinous in debt funds, whose returns are lower. In a target maturity fund, you can minimise the impact by buying during the launch and holding till maturity.

Finally, invest in ETFs through a low-cost brokerage and avoid trading in them.