How Do ETFs Work? A Beginner's Guide to ETF Investing in India

To answer how do ETFs work? First, know that an ETF allows investors to trade units of a portfolio (basket of assets) on a stock exchange. A portfolio may be designed to track a market index, hold bonds, provide exposure to gold, or any other defined basket of assets. Investors may get exposure to underlying securities of an ETF, without the need to buy all the individual securities of that ETF.

In India, units of an ETF are listed and traded on NSE and BSE, based on the listing and trading arrangements of the ETF. Investors, through their trading accounts, place orders to buy or sell units of the ETF. The units are electronically held in a Demat account. The market price of an ETF may differ from its net asset value (NAV). Tracking performance and costs may impact the experience of an investor owning an ETF.

This guide explains the mechanics of ETFs. We describe how ETF units are created and redeemed, how ETF NAVs are calculated, and what happens when units are traded. We describe the roles of authorised participants and market makers in aligning the ETF's market price with the value of the portfolio. For the broader definition and types of funds, read our complete guide to ETFs in India.

Explore ETF investments to diversify your portfolio with market-linked investment options. Get expert guidance to understand ETFs, compare available options, and start investing in line with your financial goals and risk appetite.

How Do ETFs Work? The Basic Structure

An ETF is required to pool, represent or otherwise hold the assets comprising the portfolio as stated in its scheme documents. The ETF can also achieve its investment objective through various investment or other structures permitted under the SEBI (Mutual Funds) Regulations, 1996. The way to implement an ETF’s investment objective would depend on the structure of the ETF.

An example of an ETF which tracks an index would aim to hold all the constituents of the index in the same weightage as in the index. An ETF aimed at providing exposure to gold would aim to achieve the objective through the structure(s) as described in its offer documents. A debt ETF can hold government securities, corporate bonds and other permissible fixed income securities.

When a unit of an ETF is bought, units in the ETF are purchased and not the underlying securities in the same ETF. The ETF has a pool of assets and liabilities and each unit is represented by a claim on the ETF’s net asset value (NAV). The NAV of the ETF is determined at the end of each day. Units of the ETF are, however, traded continuously throughout the day on the stock exchange and their price is determined by demand and supply in the market.

ETFs are not all index tracking funds and not all ETFs use the same investment strategy. Before considering a fund, check its investment objective and benchmark if any, portfolio holdings, costs and risks and the scheme documents.

Step 1: An ETF Holds or Tracks Underlying Assets

The first step in understanding ETF working is to identify what the fund owns or tracks. The underlying assets determine much of the ETF's performance and risk.

Index ETFs

An index ETF follows an index, usually a market equity index. The index fund may buy the constituent stocks of the index to replicate the index, or take a sampling approach to indexing (e.g. strategy sampling).

The ETF is expected to move in the same direction of the index it tracks, but may not always match the index, for instance, because of tracking differences, expenses, and other impeding factors. Tracking an index does not protect investors against market losses.

Other ETF categories

There are ETFs that offer sector and debt exposure, and other defined exposures. There are also ETFs that offer exposure to commodities and other alternative investments. A sector ETF can be more concentrated than a broad-market ETF. A debt ETF can be impacted by changes in interest-rates and the credit risk of its holdings.

Some ETFs are managed to actively follow strategies that may not replicate traditional market indices. Not all ETFs are passive and broadly diversified.

Step 2: How ETF NAV Is Calculated

Net Asset Value (NAV) means the value of a fund's assets after deduction of its liabilities, divided by the number of units outstanding. In simple terms:

NAV per unit = (Total value of assets − Total liabilities) ÷ Units outstanding

For an ETF holding shares, the value of such holdings will be assets of the fund. Cash, receivables, expenses, and other such items may affect the fund's assets. For a debt ETF, the value of the underlying securities and accrued income may affect NAV. The valuation and publication of NAV is in accordance with the relevant requirements and the scheme's disclosures.

Let us understand this with the help of an example. If a fund has net assets worth ₹ 100 crore and has 1 crore units, the NAV will be ₹ 100. This is a simple example and not an actual value or an estimate for any ETF.

NAV helps an investor in understanding the value of a fund's portfolio. However, it may not represent the price at which units of an ETF are bought and sold on the stock exchange. The price of ETF is a result of several market factors including the value of the underlying assets, expectations, orders and availability of liquidity.

Step 3: ETF Units Trade on Stock Exchanges

Unlike mutual funds, where an order is processed with the fund or an authorized participant at the fund's NAV, ETF units are traded in the secondary market. The price at which they are bought and sold depends on the order and counter-party available in the market. The bid-ask spread for an ETF may be wide because of liquidity problems.

Let's take an example where an investor has placed a buy limit order for an ETF at ₹101 and another investor is willing to sell the ETF at ₹101.10. Unless the exchange's rules allow for a match between the orders, the trade will not happen. The displayed last traded price is not an assurance that an order will be filled at that price.

In order to trade an ETF listed in India, a retail investor has to set up a trading account, a Demat account and have enough funds or units to complete the trade. To learn about the trading account set up and order process, please visit our equity trading account set up page.

Once your account set up is complete, you are ready to place orders. Before placing an order, be sure to know the ETF's exchange symbol, bid-ask spread, trading price, trading volume, order type, brokerage, and other charges. Also check the settlement procedures, regulations and exchange rules. These rules and regulations may vary with your broker.

Step 4: Understand ETF Market Price and NAV

An ETF's market price is what it trades for on the exchange. An ETF's NAV is similar to a fund's Net Asset Value, and is based on the sum of the assets less the liabilities of the fund, but can also be determined after allowing for expenses and deducting revenue.

An ETF will generally trade at a premium if it is trading above its NAV and at a discount if trading below its NAV. Determining factors will include supply and demand, the volatility of the market, the liquidity of the ETF and its underlying assets, when the market is open/closed and when prices are published.

Using this example, if the indicative value of the underlying assets of an ETF is ₹100 and the market price is ₹100.50, then the ETF is trading at a premium of ₹0.50. Conversely, if the market price is ₹99.70, then the ETF is trading at a discount of ₹0.30. Again, these are simplified examples and investors should refer to the latest values.

As a general rule, it is expected that discounts will occur with the opening of overseas markets, and premiums will occur with the closing of overseas markets. However, keep in mind that a low or high unit price of an ETF does not necessarily mean it will be cheap or expensive respectively.

Step 5: Creation and Redemption of ETF Units

ETF creation and redemption refers to the primary market transaction process that varies from retail traders' exchange traded transactions. Many ETFs have structures whereby Eligible Institutional Participants or Authorized Participants, can create new units by delivering to the ETF, a basket of securities or other assets, cash, or a combination described by the fund. Conversely, they can redeem units by giving the fund the basket or cash in exchange for the units, in line with the scheme's procedures.

The structures of ETFs, and the means, processes and procedures, prescribed in the fund's offering documents, the frameworks applicable to the fund house and the market, shall be assessed for creation and redemption. It is not the same as a retail investor placing a normal buy or sell order. Most retail investors purchase or sell units of ETFs via the secondary market, that is, by transacting with other retail investors.

What role does creation and redemption play in ETFs?

Creation and redemption may play a role if ETF units trade at a material premium or discount to the value of the portfolio. In these cases, eligible participants may have an economic incentive to use the creation or redemption mechanism, if they are available and practical. For example, if units trade at a premium, a participant may create units, sell them to the market, and thereby increase the supply. If units trade at a discount, a participant may buy units, and if the terms permit, redeem them for the underlying basket or cash.

While these activities may help make the market price align with the underlying value, there are a number of factors that may prevent complete alignment, including trading costs, market volatility, closures of the underlying markets, asset liquidity, and operational constraints.

Step 6: The Role of Authorised Participants and Market Makers

Authorised Participants may help to create and redeem ETF units and also help to arbitrage away price differences between ETF units and the portfolio. Market Makers (if any) may help to provide two-way prices to improve liquidity. Each ETF structure and sponsor may differ in terms of who may perform what role in the ETF.

Even if market makers are present, they will not ensure continuous liquidity, and the spreads may still widen. Volatility in the market may also lead to lack of liquidity in the underlying stocks, and market prices may trade at a bigger discount to NAV.

Just because an authorized participant or market maker is present, retail investors may not always expect to trade at fair value. Fund disclosures and market conditions remain key.

Step 7: Understand ETF Tracking and Tracking Error

When tracking a benchmark, an ETF may not track perfectly, and there may be variability in the difference over time. Tracking error defines variability and is determined by how the difference over time is calculated. There may be differences due to expenses, cash, rebalancing, and transaction costs, taxes, and timing. Also, differences may occur due to how the benchmark’s underlying index is replicated.

Tracking difference is also useful. It shows the difference in return and the benchmark return for a given period. While the two terms are related, they are not the same.

To learn more about this measure, review the educational guide at ETF tracking error, after confirming that the URL is live. Historical tracking performance is informative but does not guarantee future results.

Step 8: ETF Liquidity, Bid-Ask Spread and Costs

How quickly ETF units can be bought or sold, is a measure of ETF liquidity. Trading volume on an exchange is one measure of ETF liquidity, but there are other factors as well, including the liquidity of the underlying securities, participation of market makers, bid-ask spread, market conditions, and availability of arbitrage.

Bid is the price that the buyer is willing to pay, and ask is the price that the seller is willing to accept. The difference between the two is the bid-ask spread. For a trade to occur, the price has to be set at or around the ask price.

For an ETF investor, there are expenses associated with the ETFs as well. Expense ratio is the fund’s expense expressed as a percentage of the fund’s assets. However, there are other costs associated with the trade, such as brokerage costs, charges and fees, and taxes. Verify the fund’s fee schedule rather than using an old example.

ETF liquidity should not be solely determined by the number of units traded. There are other factors to consider. These may include bid-ask spreads, market conditions, size of the order, liquidity of the underlying assets, etc. Read our guide to ETF liquidity once the URL becomes active to learn more.

ETF Investing: A Practical Checklist for Beginners

1. Identify Objectives. Understand what index, asset class, or strategy the ETF covers and ensure it lines up with your goal.

2. Assess Portfolio. Check the holdings for any concentration risk and evaluate sector exposure and any risks described in the scheme documents.

3. Consider Tracking Performance. Check tracking error and tracking difference over similar time periods using information disclosed by the fund.

4. Think About Market Conditions. Look at the bid and ask for the ETF, and compare the current bid price to the NAV and the indicative price of the ETF.

5. Review total costs. Consider the expense ratio, brokerage, statutory charges, taxes and any other applicable fees.

6. Reflect On Your Order. Place a limit order and set your price where you would be comfortable selling or buying.

7. Read Official Information. Read scheme information documents and key disclosures and check the terms of trade before you buy and sell.

These checks help you determine more about an ETF, but market risk is still present. Whether an ETF is suitable depends on your individual circumstances including your investment horizon, objectives, and tolerance for losses.

How ETFs Differ from Index Mutual Funds

While ETFs and index mutual funds aim to track the same index, their transaction mechanisms differ. ETF units are traded at market prices in the exchange during market hours. Investors in ETFs may not always realize the NAV of their investment, depending on when their orders are executed. Index mutual funds process transactions through the fund’s permitted channels at the applicable NAV. The rules and cut-off timing would also apply to the mutual fund.

Other factors that investors would need to consider for ETFs include the liquidity available at the exchange, the bid-ask spread and the possible existence of a premium/discount to the NAV. Index mutual funds do not trade like shares on an exchange, but the tracking error, costs and rules pertaining to their investors’ transactions would be key. Neither of these structures promise a return, and therefore, should not be assessed on a single feature.

Conclusion

ETFs are portfolios structured to facilitate investment via exchange. To do this, they have to acquire or access exposure to the underlying assets, calculate their NAV by their valuation process, and permit their units to be traded on the exchange. Not all participants can use the creation/redemption process. Liquidity and the narrowing of the difference between the market price and the value of the underlying assets are the responsibility of market makers and other arbitrageurs.

These mechanisms do not guarantee success. Differences between the ETF market price and its NAV, deviation of tracking performance of ETFs from their benchmark, and costs, liquidity and market conditions are factors beyond the control of ETFs that can impact investor outcome. Prospective investors, especially beginners should apprise themselves of the ETF objective, consider its costs and disclosures, review trading volume and other trading conditions, and then make an informed decision on whether to trade the ETF.

When you are ready to explore the different categories and features, you can review our ETF investment information and compare the fund's stated objective and risks with your own needs.