Last Updated on October 1, 2023 at 4:53 pm
In a most dramatic example of why one should avoid all Indian ETFs, SBI ETF Nifty 50 which has Rs. 64,464 Cr of AUM displayed an atrocious disparity between its price and NAV. Here is why it happened.
What happened? SBI ETF Nifty 50 closed on 13th Mar 2020 with a NAV of 105.3 and price of 97.17. It closed 16th Mar 2020 with a NAV of 97.17, a fall of 7.7% while Nifty fell 7.6% (tracking error would account for the difference). The closing price on 16th was 104.81!! Just 0.2% down from 13th.
So the NAV changed by -7.7% while the price fell only -0.2%. At the time of writing (17th Mar 9:42 am) this discrepancy has been significantly corrected and the current price is 97.57. Let us find out the cause of this discrepancy.
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An exchange-traded fund (ETF) is one in which each unit of the fund (a basket of stocks or bonds) is traded among other unitholders via a demat account. How easily one is able to buy and sell these ETF units is referred to as liquidity.
If you wish to understand the basics of ETFs, you can start here: How ETFs are different from Mutual Funds: A Beginner’s Guide and here: List of Index Mutual Funds and ETFs in India: What to choose and what to avoid and here(!) Watch my talk on index investing: Can we get higher returns with lower risk?
Since the ETF trades at the exchange, the price of each unit need not equal its NAV and is decided by supply and demand. A large and consistent discrepancy bet the price and NAV is unhealthy and indicates that it is hard to trade those ETF units. Large AUM ETFs will heavy daily trading volumes almost always exhibit a low difference between price and NAV, suggesting that it is quite liquid. However, this does not mean, that low AUM etfs are always ill-liquid.
ETFs provide an arbitrage opportunity and this can ensure even a low AUM ETF maintains a low price-nav difference via authorized participants (AP). They are large banks or brokers capable of high volume tradings. APs can trade with etf unitholders at the exchange (secondary market) at the current price of the ETF and directly with AMC (primary market) at the NAV.
Suppose an ETF trades at a price higher than its NAV. This means the stocks that are part of the ETF are more expensive when purchased as part of the ETF compared to when purchased separately. So an AP can borrow units from the AMC and sell this to unitholders. At the same time, they will also but a corresponding amount of stocks (that make up those units). At the end of the trading day, they will give the AMC the underlying stocks corresponding to the borrowed units The profit is the difference between the cost of the ETF units and cost of the stocks directly purchased after expenses.
If the ETF trades at a price lower than the NAV, the AP will buy ETF units and sell the underlying stocks after borrowing it from the AMC. At the end of the day, they will return the ETF units in exchange for the borrowed securities. Again the profit is the difference in the price of the units and the underlying stocks.
In other words, when the ETF trades above NAV, the APs inject units until the difference is small. When the ETF trades below NAV, the APs remove units until the price increases sufficiently. Thus the presence of an AP ensures that the price-nav difference is low, making the ETF easier to trade. Hence liquidity depends on how active the APs are and not on the AUM of the ETF. The mere presence of an AP (which all ETFs have) is not enough. They must actively maintain liquidity in the ETF. This can be seen from the number of daily units traded. Read more: Debunking ETF liquidity myths
The bottom line, the AP was not or could not be active enough on a day when prospective ETF unitholders wanted them most. There cannot be a clearer proof or justification for an investor to avoid all ETFs. Otherwise, the market losses could be too high at the time of purchase or sale.
Want more proof? See: SBI ETF Nifty 50 vs UTI Nifty Index Fund: Which is Better?
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