PROSPERR.IO

What is an ETF?

Investing today can feel like navigating a maze — there are just too many choices. Among these, one investment option that’s steadily rising in popularity is the ETF, or Exchange-Traded Fund.

Simply put, an ETF is an investment fund that pools money to buy a mix of assets such as stocks, bonds, or money market instruments. Most ETFs are designed to track the performance of a specific market index, giving investors an easy way to mirror the market’s movement without needing to pick individual stocks.

What makes ETFs so attractive is their flexibility. They’re listed and traded on stock exchanges just like regular stocks, which means investors can buy or sell them throughout the day at market prices. In short, ETFs offer the diversification of mutual funds combined with the trading convenience of stocks — the best of both worlds.

India’s journey with ETFs began in 2002, when Benchmark Mutual Fund (now Nippon Life India Asset Management) launched the Nifty BeES ETF, the first of its kind in the country. Its goal was straightforward — to track the performance of the Nifty 50 index — and it set the foundation for how ETFs are used in India today.

Types of ETFs:

1. Equity ETFs: Equity ETFs aim to replicate the performance of major stock indices or specific sectors such as banking, IT, or energy. Their goal is to deliver returns that move in line with their respective benchmark indices, providing a low-cost, diversified way to invest in equities.

2. Gold & Silver ETFs: Gold has always been a favorite among Indian investors — it’s a traditional hedge against inflation and currency fluctuations. However, physical gold comes with issues such as storage, purity, and resale hassles. Gold ETFs solve these problems by investing in gold bullion, giving investors an easy and secure way to gain exposure to gold without owning it physically. The same logic applies to Silver ETFs, which offer exposure to silver prices in a similar way.

3. International ETFs: These ETFs give Indian investors a gateway to global markets. By tracking foreign stock indices, they allow participation in the growth of global economies like the U.S., Europe, or emerging markets — all while remaining listed on Indian exchanges.

4. Debt ETFs: Debt ETFs invest in fixed-income instruments such as government securities or corporate bonds. They trade on the NSE just like equity ETFs, usually at lower costs than traditional debt mutual funds. With high transparency, liquidity, and low expense ratios, they’re becoming increasingly popular among conservative investors.

Why Invest in an ETF?

ETFs are one of the easiest and most efficient ways to gain exposure to entire markets, sectors, or investment themes. For investors who prefer tracking an index rather than actively selecting securities, ETFs provide simplicity and control.

Key Benefits:

• Low Cost: ETFs generally have much lower expense ratios than actively managed mutual funds. While mutual funds might charge 1–2% annually, most ETFs cost less than 0.1%. Over time, that small difference can significantly boost your returns.
  
• Flexible Trading: Unlike mutual funds, which are priced only once at the end of the day, ETFs can be bought and sold throughout market hours at live market prices. This allows better transparency and flexibility in managing your portfolio.

Key Terminologies in ETFs:

1. NAV (Net Asset Value): The NAV represents the total value of all the ETF’s underlying assets per unit. It’s calculated at the end of each trading day but doesn’t necessarily match the ETF’s market price.

2. iNAV (Indicative Net Asset Value): The iNAV provides a real-time estimate of an ETF’s NAV during market hours. It reflects the current market value of the ETF’s holdings, updating every few seconds. Checking the iNAV helps investors see whether an ETF is trading at a premium or discount.

3. Total Expense Ratio (TER): This is the annual management fee expressed as a percentage of assets. A lower TER makes the ETF more efficient, especially for long-term investors.

4. Tracking Error: This measures how closely the ETF’s returns match those of its benchmark index. A lower tracking error means the ETF is doing a good job of mirroring its index.

5. Liquidity: Liquidity indicates how easily you can buy or sell ETF units on the exchange without significantly affecting the price. High liquidity ensures smoother trading.

6. Bid–Ask Spread: This is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller will accept (ask). Narrow spreads are better for investors as they minimize trading costs.

7. Market Price: The actual trading price of the ETF on the exchange, which can be slightly above or below its NAV depending on demand and supply. Things to Consider Before Buying an ETF.

Premium and Discount in ETFs: Unlike mutual funds — where units are allotted based on that day’s closing NAV — ETFs trade on exchanges in real time, and prices can fluctuate through the day based on demand and supply.

Sometimes, the market price of an ETF may be higher than its iNAV, meaning it’s trading at a premium. This typically happens with international or thematic ETFs, where investor demand exceeds supply.

Exhibit 1: Compares the ETF’s market price and NAV as of 11 July 2025.

A major reason why international ETFs in India trade at a premium is due to regulatory limits on overseas investments by mutual funds. These restrictions cause supply–demand imbalances that push ETF prices above their fair value.

The limits are as follows:

• Industry-wide Limit: USD 7 billion for all overseas investments by Indian mutual funds.
• ETF-specific Limit: USD 1 billion for international ETFs.
• AMC-specific Limit: Each Asset Management Company can invest up to USD 1 billion in overseas securities.

Since these limits are fully utilized, new investments have been paused. Limited availability, combined with steady investor demand, has led many international ETFs to trade at a premium over NAV.

Conversely, when an ETF’s market price falls below its iNAV, it trades at a discount — meaning there are more sellers than buyers. However, discounts are relatively uncommon in the Indian market.

Exhibit 2: Compares the Nippon India Infra ETF’s market price and NAV as of 11 July 2025.

Before investing, always check whether an ETF is trading at a premium or discount to ensure you enter at a fair value.

Liquidity: Liquidity is crucial for ETFs. Funds with higher Assets Under Management (AUM) tend to have better liquidity and active trading. This helps investors buy or exit positions more efficiently without causing large price swings.

Tracking Error: Tracking Error (%) indicates how consistently a passive fund — like an ETF or index fund — tracks its benchmark index. It’s calculated as the annualized standard deviation of the difference in returns between the fund and its benchmark over a specific period (such as 1 month, 1 year, or 3 years).

A lower tracking error means the ETF is replicating the index more accurately. A higher tracking error suggests deviation from the benchmark — something investors should watch closely.

Exhibit 3: Shows the 3-year monthly average tracking error of selected ETFs in India.

Tracking Difference: Tracking Difference (%) represents the actual difference in returns between the ETF and its benchmark over a period. It can be positive (outperformance) or negative (underperformance), though it’s usually slightly negative because of fund expenses like the TER.

While tracking difference shows how far the ETF’s returns are from the index in absolute terms, tracking error reveals how stable that gap is over time. Both are key indicators of how efficiently a passive fund performs.

Final Thoughts:

ETFs are an excellent tool for investors who prefer a passive investment approach. They offer broad diversification across asset classes, sectors, and geographies — all while keeping costs low and trading simple.

If your investment philosophy is to track the market rather than beat it, ETFs can be a smart and efficient way to grow your wealth steadily. The key is to choose ETFs with:

• Low tracking error

• High liquidity

• Market price close to NAV

With disciplined investing and a long-term perspective, ETFs can form the backbone of a cost-effective portfolio that grows efficiently over time.

Disclaimer: Investment in the securities market is subject to market risks. Read all related documents carefully before investing.