Over the past few months, exchange traded funds have increased in popularity among investors. In special demand are the gold exchange traded funds (ETFs), which have found many takers due to the surging interest for gold as an investment.
These passively managed funds offer many advantages to the investor. They assure convenience, transparency in pricing, means for diversification at a low cost and, supposedly, more liquidity. Unlike in a mutual fund, where units are allotted on the basis of the NAV at the end of the day, ETFs can be traded in real time during market hours.
However, not all ETFs muster a good volume on the exchange. In fact, many schemes suffer from a dearth of trading volume. Why is this? Lakshmi Iyer, head, fixed income and products, Kotak Mutual Fund, believes it will take time to create a vibrant, active market for ETFs as it is a relatively new concept.
"ETF is more of a push product than a pull one. Also, in India, traders and brokers are not sufficiently incentivised to create an active secondary market around it," she says. This poses difficulties for those who have already invested in these illiquid funds. Here's how a low trading volume could impact your ETF investment.
High impact cost: The most direct effect of the absence of liquidity is the undesirably wide difference in the bidding and asking prices, or impact cost, while transacting in ETFs. This is the gap between the price that the buyers are willing to pay for the units of an ETF and the price that the sellers are asking for. The greater the spread, the more you lose every time you transact on the exchange. How does this happen?
In a low-volume market, you could end up buying units at a price higher than that you would have wanted. On the other hand, you may be forced to sell at a price less than that you had hoped for. This is because there are no buyers (or sellers) willing to pay (or accept) the price at which you want to trade. A high impact cost can eat into your overall returns.
Gap between NAV and market price: The lack of liquidity may also lead to price manipulation and, thereby, create a gap between the net asset value (NAV) of the ETF and its market price. In some cases, the ETF may trade at a substantial premium or discount to the value of its underlying portfolio. For a buyer, this could mean that he could be paying much more for the ETF than the real worth of its holdings. For the seller, it could fetch much less than the actual worth of the basket of securities.
Lack of exit option in crisis: The stocks of most small- and mid-cap companies are characterised by low liquidity on the bourses. During a market turmoil, liquidity on these counters dries up as fast as the buyers, so the investors are unable to offload their shares before it is too late. Investors in illiquid ETFs could face the same situation. In such a case, one could eventually end up selling for much less than desired, or worse, get stuck with the fund. Though the offer documents of most ETFs contain provisions to buy back units directly from the investors (when there is no continuous trading for several days), it might become too late to do so.
What you should do
To avoid falling into this liquidity trap, don't follow the latest fads blindly. The rush to invest in gold ETFs currently is the best example of this phenomenon. Rarely do investors check the volume of a fund before buying it.
Second, do not be in a hurry to buy a new fund. Wait for a while to get an idea about its trading volume and take a plunge only after making sure that there is enough trading. The relevant data is available on the websites of both the stock exchanges, BSE and NSE. Also, don't go by the trading volume for a single day as it may not reflect the actual liquidity of the product. Check the volume over a span of at least a month.
Third, understand what drives the liquidity of the ETF and get in only if you are sure that there will be enough in the future. For example, a strong market maker system put in place by the fund house can generate sufficient liquidity. A market maker is someone who can buy/sell funds directly from the mutual fund house. He can also place buy and sell orders simultaneously at the prevailing market price so that there is enough opportunity for both buyers and sellers to get their orders.
The liquidity of the underlying portfolio of the ETF is another factor. For instance, ETFs that invest in large-cap companies or broad market indices are least likely to face liquidity problems. On the other hand, since small- and mid-cap companies are not traded as widely, the schemes that hold them may have a low trading volume.
Lastly, you can opt to place limit orders so that you don't lose out while trading in ETFs. This will ensure that your trade is executed only at the price you specify, otherwise you will have to make do with whatever price the market arrives at. Rajan Mehta, executive director, Benchmark Mutual Fund says, "Investors would do well to place a limit order closer to the real-time NAV for a fund. But keep in mind that a limit order may not always be executed in case of a low-volume ETF."
Source: http://articles.economictimes.indiatimes.com/2011-05-30/news/29594823_1_etfs-gold-exchange-exchange-traded-funds
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