Exchange Traded Funds

29.1 – Introduction to ETFs

Imagine you invest in a mutual fund today. Your money is pooled with thousands of others, and at the end of the day the fund house calculates the value of all holdings, divides it by the number of units, and declares the NAV. You only know your purchase price that evening, when the NAV is published (by 11 pm). Now contrast that with buying shares of Infosys or Reliance—you see the price instantly, and you can buy or sell at any moment during market hours.

Exchange Traded Funds (ETFs) combine these two worlds. They are baskets of securities like mutual funds, but they trade on the stock exchange in real time like shares. This means you can react immediately to market movements, rather than waiting for end of day NAVs. For example, if you believe banking stocks will rally after a policy announcement, you can buy a Bank ETF at 11:05 AM and sell it at 3:15 PM the same day, before the market closes at 3:30 PM. That flexibility is the defining feature of ETFs.

29.2 – The Evolution of ETFs

Mutual funds have a century-long history. The first modern open-ended fund in the US dates back to 1924, while India’s journey began in 1964 with the Unit Trust of India. ETFs, however, are a much younger innovation. The first widely recognized ETF, the SPDR S&P 500 (ticker: SPY), launched in 1993, and today it is one of the most heavily traded securities globally.

India entered the ETF space with Nifty BeES, which tracks the Nifty 50 index; it was launched in December 2001 and listed in January 2002. Over time, ownership changed hands—from Benchmark AMC to Goldman Sachs, then Reliance, and now Nippon India Mutual Fund. This journey reflects how ETFs have grown from niche products into mainstream instruments worldwide.

29.3 – ETFs in the Indian Context

Despite being available for over two decades, ETFs in India are still dominated by institutional investors rather than retail participants. For instance, the SBI Nifty 50 ETF has assets of over ₹2 lakh crore (October 2026), largely because the Employees’ Provident Fund Organisation (EPFO) invests heavily in it. Similarly, government divestment programs like CPSE ETF and Bharat 22 ETF have boosted ETF assets, but again, retail investors form only a small fraction.

One reason for limited retail adoption is accessibility. Unlike mutual funds, which can be bought directly through apps or distributors, ETFs require a demat account and stock market familiarity. Another reason is incentives—mutual funds pay distributors commissions, so they are actively marketed. ETFs, with thinner margins, don’t get the same push. As a result, while ETFs are growing steadily, they remain underpenetrated compared to mutual funds.

29.4 – What Exactly is an ETF?

Think of an ETF as a “wrapper” holding a portfolio of securities. If you buy a Nifty 50 ETF, you are indirectly owning all 50 companies in the index in the same proportion. The difference from mutual funds is immediacy—you can buy or sell ETF units on the exchange at any time during trading hours.

For example, if you search for “Nifty ETF” on your broker’s platform, you’ll see multiple options from different fund houses, all tracking the same index. The choice then depends on liquidity, expense ratio, and tracking accuracy.

29.5 – How ETFs Operate

Mutual funds interact directly with investors—when you invest, the AMC buys securities and later redeems them when you exit. ETFs, however, mostly bypass the AMC. Transactions happen between buyers and sellers on the exchange. If you sell your ETF units, another investor buys them; the AMC isn’t involved in day to day trading. This makes ETFs more market-driven and dependent on liquidity.

29.6 – Creation and Redemption Mechanism

Here’s where ETFs get interesting. Large investors or market makers can directly create or redeem ETF units with the AMC in bulk, known as “creation units.” Creation units are large blocks, typically tens of thousands of units worth ₹1 crore or more, and SEBI permits investors other than market makers to deal directly with the AMC only for transactions above ₹25 crore. Institutions can deliver the underlying basket of Nifty stocks to the AMC, receive ETF units, and then sell them on the exchange.

This mechanism ensures liquidity and keeps ETF prices aligned with their NAV. If ETFs trade at a premium, market makers create units at NAV and sell them at higher market prices, profiting while correcting the imbalance. If they trade at a discount, they buy ETF units cheaply, redeem them with the AMC for underlying shares, and sell those shares in the market. This arbitrage keeps ETFs close to fair value.

A striking example was the Motilal Oswal NASDAQ 100 ETF, which at times traded at premiums of around 20% when fresh unit creation was constrained (including by the overseas investment limits on Indian mutual funds) and market makers could not arbitrage the gap. Once creation resumed and liquidity providers stepped in, the gap narrowed, showing how crucial this mechanism is.

29.7 – Understanding ETF Liquidity

Liquidity in ETFs isn’t just about daily trading volumes or AUM. There are multiple layers:

1. Secondary market liquidity– What you see on your trading screen, i.e., bid-ask spreads and volumes.
2. Market depth– The hidden liquidity provided by market makers, who stand ready to buy or sell large quantities.
3. Primary market liquidity– Institutions can always create new units directly with the AMC.
4. Underlying stock liquidity– Ultimately, an ETF is only as liquid as the securities it holds.

For example, India had no small-cap ETFs for many years  because small-cap stocks often hit upper or lower circuits and lack sufficient liquidity. A sudden surge in demand can make it very hard for market makers to create units, leading to distorted premiums. In contrast, large-cap ETFs like Nifty 50 ETFs remain liquid because their underlying stocks are actively traded.

29.8 – Types of ETFs in India

India now offers more than 200 ETFs, and industry ETF assets crossed ₹10 lakh crore in October 2025. They are mostly equity-based. Broadly, they fall into three categories:

• Equity ETFs– These include plain vanilla index trackers like Nifty 50 or Sensex, as well as smart beta ETFs that focus on factors like low volatility or momentum.
• Debt ETFs– Examples include Bharat Bond ETFs, which invest in PSU bonds, and G-sec ETFs.
• Commodity ETFs– Gold ETFs dominate this space, followed by silver ETFs 

While most ETFs are passive, tracking indices, smart beta ETFs blur the line by applying rules-based strategies. Globally, active ETFs are emerging, and India may eventually see them too.

29.9 – ETFs vs Index Funds

Both ETFs and index funds aim to replicate an index, but they differ in mechanics. Index funds are priced once daily at NAV, while ETFs trade in real time. This makes ETFs more flexible for tactical strategies, like buying during intraday dips.

However, ETFs come with bid-ask spreads and brokerage charges, while index funds are simpler—no trading costs, easy SIP setup, and no liquidity concerns. For a long-term passive investor, index funds may be easier. For someone who wants flexibility and intraday control, ETFs are better.

For example, if you want to systematically invest ₹5,000 every month without worrying about timing, an index fund works well. But if you want to quickly exit during a market rally, ETFs give you that option.

29.10 – ETFs vs Actively Managed Funds

Globally, studies show that most actively managed funds fail to beat their benchmarks. In the US, nearly 90% of active funds underperform over long periods. In India too, SPIVA reports reveal that more than 70% of large-cap funds lag behind indices like Nifty 50.

The main reason is cost. Active funds charge around 1.5% annually, while index funds or ETFs tracking Nifty 50 may cost just 0.1%. Over time, this difference compounds significantly. For instance, if two funds both earn 12% gross returns, the active fund investor may only see 10.5% after costs, while the ETF investor enjoys 11.9%.

Even in mid-caps, where active managers were once thought to have an edge, many funds now struggle to beat benchmarks like Nifty Midcap 150. The market has become more efficient, reducing opportunities for stock pickers. As a result, broad based ETFs and index funds increasingly look like smarter choices for most investors.

Key Takeaways

• ETFs trade in real time, unlike mutual funds.
• Liquidity is layered—don’t judge ETFs only by AUM or daily volumes.
• Always use limit orders and check iNAV before trading.
• Compare ETF prices with NAVs and underlying indices to avoid surprises.
• For large investments, consider creating units directly with the AMC (permitted for transactions above ₹25 crore).
• In India, large-cap and mid-cap ETFs often outperform actively managed funds due to lower costs and efficiency.