Passive investments have seen significant growth in recent times, driven by increased investor interest in the benefits they offer. According to te Association of Mutual Funds in India (AMFI), the share of passive funds in the mutual fund industry grew from 5.8% in April 2019 to 17.5% in March 2024.
Passive investing involves tracking a market index using exchange traded funds (ETFs) and index funds rather than actively picking stocks. This translates to lower fund management fees and a lower risk of under-performance from poor stock selection. Unlike mutual funds, ETFs can be traded throughout the day on exchanges, much like stocks, giving investors the chance to buy and sell them instantly.
When investing in mutual funds, you only need to chheck a fund’s total expense ratio (TER) to understand the cost of investing in it. But with ETFs, you need to look at several other things as well.
The overall cost of an ETF includes trading fees, bid-ask spreads, and expense ratios apart from the TER. The spread in ETFs can be a significant hidden cost if there is a large difference between the bid and ask prices. There are also statutory costs of trading on exchanges, but more on that later.
What is ‘the spread’ in ETFs?
The spread is the difference between the price at which you can buy an ETF (the ask price) and the price at which you can sell it (the bid price). This gap is where market makers or brokers make their money. When you go to buy an ETF, just like stocks, you’ll typically pay the ask price, which is the lowest price someone is willing to sell it for. Conversely, if you’re selling, you’ll get the bid price, which is the highest price someone is willing to pay. The difference between these two prices is called ‘the spread’.
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It’s lower when lots of buyers and sellers are trading the ETF. Popular ETFs with large AUMs (assets under management) typically have narrow spreads because they are being traded all the time.
What happens when the spread is wide?
If an ETF isn’t traded very often, the spread can widen because there aren’t many participants to keep the prices close together. Examples of these include ETFs with low AUM or sectoral ETFs. During times of volatility, spreads can widen as market makers try to protect themselves from rapid price movements.
According to a senior executive at a fund house, during the recent market volatility before and after election results, the ETF spreads were wide as market makers didn’t have enough capital to handle the high volumes during those two days.
How does the spread affect you?
When you buy an ETF with a high spread, you’re paying a bit more than its market value. Similarly when you sell, you’re getting a bit less than the market value because you’re selling at the lower bid price. This is an indirect cost you incur when you enter and exit an ETF. It’s not a fee you see directly, but it does affect your overall returns.
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Mutual funds are required to update the intraday net asset values (iNAVs) of ETFs on their websites every 15 seconds during market hours. You can check whether the ETF is trading at a premium or at a discount to its iNAV when buying or selling it.
To minimise the impact of the spread, try to trade ETFs during times of high liquidity and stable market conditions. Avoid trading in volatile markets unless necessary. Understanding the spread and how it works can help you make more informed decisions and potentially save on costs when trading ETFs.
Broking and other costs
As ETFs are traded on exchanges, you need a broker to execute trades. This means there is a brokerage cost involved as well. This cost depends on the broker you choose for and duration for which you hold the ETF. There is also 18% GST on brokerage. Typically, discount brokerages don’t charge for delivery trades (those in which you hold the investment beyond the current trading day).
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There are also statutory costs of investing in ETFs, such as a securities transaction tax of 0.1% (on purchase), stamp duty of 0.015%, and Sebi turnover fees of 0.0001% of the transaction value. These charges apply even to delivery trades.
Should you invest in ETFs?
An ETF is suitable for investors who want the flexibility to enter or exit during market hours and benefit from the highs and lows. As with stocks, you’ll need a demat account to invest in ETFs.
If you don’t want to open a broking account, pay additional costs or trade at intraday market prices, simply look for an index fund with low TER and a long track-record.
“Index funds are suitable for investors simply looking for end-of-day NAV-based pricing, like regular mutual funds,” said Anil Ghelani, head of passive investments and products at DSP Mutual Fund.
