What Is an ETF?
Since the 1995 launch of the first ETF based on the S&P 500 Index, Exchange Traded Funds have become a cornerstone of modern portfolio construction. In India, the landmark moment was the NASDAQ 100 ETF — a product that brought global index exposure to Indian retail investors for the first time.
An ETF is best understood as a hybrid of two familiar instruments: it holds assets like a mutual fund, but trades on a stock exchange like a share. This combination gives it properties that neither instrument has alone.
| Feature | Mutual Fund | ETF | Individual Share |
|---|---|---|---|
| Traded on exchange? | No — via AMC/distributor | Yes — like a share | Yes |
| Intraday pricing? | No — end-of-day NAV | Yes — iNAV published continuously | Yes — market price |
| Creation/Redemption? | Open-ended: yes via AMC | Yes — via exchange AND AMC | No — fixed shares |
| Expense ratio? | 0.5–2.5% (active funds) | 0.05–0.35% (index ETFs) | N/A — brokerage only |
| Diversification? | Yes | Yes — same basket | Single company risk |
The Mechanics: How ETF Units Are Created
Understanding ETF creation is key to understanding why ETFs behave the way they do. At the inception of a fund, the Asset Management Company seeds the fund by issuing units to both investors and Authorised Participants (APs).
Once listed on an exchange, two distinct markets exist simultaneously:
- The secondary market: ETF units trade between investors on the exchange, exactly like shares. Price is determined by supply and demand.
- The primary market: Large investors and Authorised Participants can create new ETF units by delivering the underlying basket of shares to the AMC — or redeem units by returning them to the AMC in exchange for the underlying shares.
India-specific note: Unlike some global markets, India does not distinguish between investors and Authorised Participants for creation/redemption. Anyone can create and redeem units directly with the AMC in Creation Unit lots. This increases market access but means the arbitrage mechanism works differently than in some developed markets.
The Most Misunderstood Thing About ETFs: Liquidity
ETF liquidity is the most studied — and most misunderstood — aspect of these instruments. The common assumption is that an ETF's liquidity is determined by how much it trades on the exchange. This is a myth.
The key insight: ETF trading volume on the exchange is an indicator of the fund's popularity and past trading activity — not of how liquid it actually is. The true measure of ETF liquidity is the liquidity of its underlying basket of constituent stocks.
An Illustration
Imagine an ETF that trades over 1 million units per day — it looks highly liquid. But suppose this ETF holds 5 very liquid large-cap stocks and one very illiquid small-cap. If a large investor wants to buy in and new units must be created, that small-cap may not have enough market volume to be included in the creation basket. New units cannot be created in their original form.
The reverse is equally true: a thinly traded ETF can be very liquid if its underlying stocks are highly liquid. The exchange trading volume is almost irrelevant to the fundamental liquidity question.
Sources of ETF Liquidity
Liquidity in an ETF comes from three sources, in order of importance:
- Liquidity of constituent stocks — the primary source. If the underlying basket is liquid, large orders can be absorbed through creation/redemption.
- Creation and redemption by Authorised Participants — when APs create units (buying the basket) or redeem units (selling the basket), they add or remove liquidity from the market.
- Market making by broker-dealers — including upstairs (dark pool) liquidity for large trades, which experienced advisors can access for better execution.
Practical implication for investors: When assessing an ETF, look at the liquidity and market capitalisation of the underlying index constituents — not just the daily traded volume of the ETF units themselves. For large trades, using limit orders or working with upstairs liquidity providers produces significantly better execution than market orders.
ETFs vs Index Funds: What's the Difference?
Index funds predate ETFs and have served investors well for decades. Both track an index; the differences are structural and have real implications for cost and efficiency.
| Aspect | Index Fund | ETF |
|---|---|---|
| Trading | Via AMC at end-of-day NAV | On exchange throughout the day |
| Minimum investment | As low as ₹500 (SIP) | Price of one unit (varies) |
| Cost of other investors' actions | Borne by all remaining investors | Borne only by the investor transacting |
| Tracking error risk | Higher — cash drag, redemption pressure | Lower — creation/redemption in-kind |
| Expense ratio | Typically slightly higher | Typically lower |
| Intraday flexibility | None | Full — can trade any time market is open |
The Hidden Cost of Index Funds: Investor Dilution
In an index fund, when one investor redeems, the fund must sell securities to pay them out. If a US-exposure index fund receives a redemption request in India, it must sell US stocks (settling T+5) while paying redemption at current FX and stock values. The price risk between trade and settlement is borne by remaining investors — not the redeeming investor.
In an ETF, all costs of creation and redemption are borne entirely by the investor transacting. Remaining investors are insulated from others' actions.
When Is an Index Fund Better?
ETFs are almost always the better instrument — but not always. Index funds may be preferable for:
- Very small investors (below ₹500) who cannot afford a single ETF unit
- Investors without demat or trading accounts
- Systematic Investment Plans where automated monthly investing is the priority and intraday trading is irrelevant
The bottom line: ETFs are building blocks, not trading vehicles. The decision between an ETF and an index fund is just one step in the asset allocation process — and it comes after understanding your risk profile, time horizon, and investment strategy. Both instruments serve a purpose; the right choice depends on your specific situation.