How an ETF Works: From the Basket to the Traded Unit

An exchange traded fund holds a portfolio built to a stated index rule, issues and cancels its units only in large blocks, each one dealt directly with the scheme, and lets everyone else trade those units with one another on an exchange. Two prices therefore exist at the same moment: the value computed from the portfolio, and the price at which the last transfer between holders happened. A holder receives the second one.

Almost every confusion about this structure comes from collapsing those two prices into one. Read the sentences above again slowly. An exchange traded fundA pooled scheme whose units are listed and transferred on an exchange, so most holders buy and sell them from other holders rather than from the scheme. is not a new kind of financial claim. The fund is the same pooled scheme already familiar from every other structure, issuing the same kind of unit, with one thing bolted on: a second place where those units can change hands. The second place is the whole story, and every further complication about the structure follows from it.

Think about a wedding kitchen for a moment. One enormous pot of food is cooked to a written menu, and everybody who paid gets a share of the pot. The pot is a pooled scheme. Now imagine that, halfway through the evening, guests start swapping their coupons for that pot among themselves at the gate, at whatever price the two of them settle on. The pot has not changed. The menu has not changed. The kitchen is not involved in a single one of those swaps. But there are now two numbers in the room: what a share of the pot is actually worth, and what the last two guests at the gate agreed on. Everything difficult about an exchange traded fund is the distance between those two numbers, and who ends up carrying it.

Two schemes supply every figure below, and neither of them is exchange traded. Girnar Asset Management Limited, an invented manager, runs the Girnar Large Cap Equity Fund, an actively managed equity scheme, and the Girnar Broad Market Index Fund, an index fund following a broad index that is never named. The index fund is not exchange traded either. So the parts of the structure both schemes share carry worked arithmetic, and the parts only an exchange traded scheme would have carry none. Which is which is said each time.

What decides what an exchange traded fund holds?

A stated rule does, and nobody at the scheme adds a judgement to it. The scheme declares an index it will follow, and the index has its own published rule for what belongs in it and in what proportion. From that moment the portfolio is a consequence rather than a choice. When the index changes, the portfolio changes to match it. When the index does not change, the portfolio sits still, even if the people running it would privately have preferred it otherwise.

Naming an index converts the scheme's job from a judgemental one into an operational one. The question stops being what is worth holding and becomes how faithfully and how cheaply the stated holdings can be assembled, kept in line and adjusted when the rule moves. Kalyani Bhagat manages the Girnar Large Cap Equity Fund and spends her working day on the first question. A tracker's working day is spent entirely on the second.

Here is the part that surprises people, and it matters for everything below. Following a rule is not what makes an exchange traded fund different from anything else. The Girnar Broad Market Index Fund follows a rule in exactly this way, holds a portfolio that is a consequence rather than a choice in exactly this way, and is not exchange traded at all. Following an index is a statement about how the portfolio is decided. Nothing in that statement says where the units are transacted. How the portfolio is decided and where the units are transacted get tangled together constantly, and the rest of the structure only makes sense once the two are pulled apart.

How do its units get onto an exchange in the first place?

Somebody has to deal with the scheme first, and that somebody is not an ordinary holder. A participantA large firm permitted to deal directly with the scheme in whole blocks, delivering or receiving the holdings themselves rather than money. deals a large block directly with the scheme. The participant hands over the basketThe slice of the scheme's actual holdings, in the right proportions, that a block of units corresponds to. of holdings, or their value, and the scheme issues a block of new units against it. Only once those units exist can they be transacted anywhere.

Units do not appear on an exchange because the scheme is listed; they appear because somebody dealt a block for them first. Dealing with the scheme first and trading second is the correct order, and it is almost always reversed. A reader picturing the exchange as the source of the units will never be able to explain where the very first unit came from, or why the number in issue changes on some days and not others.

How a block is assembled, delivered, issued and cancelled, what goes out when one comes back, and why delivering holdings rather than money changes who pays for the dealing, is taken apart in full elsewhere on this platform. Only one thing from that process matters below: the scheme deals in blocks with a participant, and it deals with nobody else.

What happens when an ordinary holder buys or sells?

The purchase is from another holder, and that is the entire event. The money reaches the seller. The seller's units reach the buyer. The scheme is not a party to the transaction, does not see it, and is not changed by it. Nothing is issued. Nothing is cancelled. The number of units in existence at the end of the day is exactly what it was at the start, unless a block happened to be dealt separately.

The scheme receives nothing, issues nothing and cancels nothing when an ordinary holder buys or sells on an exchange, and every step that follows depends on being clear about that. Readers get this step wrong more often than any other, and the reason is habit. In an ordinary open ended scheme the money genuinely reaches the scheme and genuinely creates units. Here it does not.

Buying a second hand scooter from a neighbour is the same shape. Money goes to the neighbour. The scooter changes hands. The manufacturer receives nothing, builds nothing and scraps nothing, and the number of scooters in the country is unchanged. New scooters get built through an entirely separate channel, at a factory, in production runs, on a different timetable, dealing with dealers rather than with anybody on the street.

Why do two prices exist for the same units at the same moment?

Because two separate processes are running, and each one produces a number. Neither is watching the other.

The first process belongs to the scheme. The scheme holds a portfolio, that portfolio is valued by the scheme's own valuation process on its own timetable, and the result is divided by the units in issue. The result is a computed valueA figure worked out from what the scheme holds, divided by the units in issue. It describes the scheme, and nobody has to transact at it.. The computed value is a statement about the scheme, arrived at by arithmetic on holdings.

The second process belongs to whoever is buying and selling. Someone wants units this morning. Someone else wants out. Their two orders meet, a transfer happens, and that transfer has a price. The result is a traded priceThe price at which the last transfer of units between two holders actually happened. It describes a transaction, not the portfolio.. The traded price is a statement about a transaction, arrived at by two parties agreeing.

No mechanical link between the two numbers exists, so nothing in the structure sets them equal. The scheme does not publish the traded price. The exchange does not compute the value. No party is under an obligation to make one match the other. The two numbers stay near each other for a reason set out below, and that reason is an incentive rather than a rule.

What keeps those two prices close, and how close is close?

An incentive keeps them close, and the incentive runs out before the difference reaches zero. Both halves hold at once, and dropping either one produces a wrong account of the structure.

Here is the first half. A participant can deal a block directly with the scheme at the value of the basket. So if the traded price on the exchange sits meaningfully above that value, the participant can obtain units on the terms the scheme offers and sell them where they are dearer, and every time it does so it adds units to the exchange and pushes the traded price down towards the value. If the traded price sits meaningfully below, the trade runs the other way. The distance narrows because narrowing it pays somebody, not because anybody is obliged to narrow it.

Now the second half, the one people skip. Acting on the difference is itself work, and work costs something. Assembling or unwinding a basket, moving it, and dealing on the exchange all consume something, and none of it is free. So the participant stops when what is left of the difference no longer covers what it takes to capture it. The distance therefore closes to the point where acting on it stops paying. The stopping point is neither zero nor a fixed number, and it moves with how hard the work happens to be on that day.

A vegetable seller two streets away is charging four rupees more per kilo than the wholesale market. Somebody with a cycle will go and fetch a sack, and keep doing it until the price difference no longer covers the trip. The gap never quite closes, and how near it closes depends on how far the ride is that week. The mechanism supplies a reason to close the gap; it does not supply a promise that the gap is closed.

Which price does the holder actually receive?

The traded price, every time. The traded price is the practical heart of the whole structure, and it is worth stating without a hedge: when a holder buys or sells exchange traded units on an exchange, the number transacted at is the number two parties agreed on, and it is the only number that touched that holder's bank account.

The computed value is not a price the holder was offered and declined. The computed value is a number about the scheme, produced by the scheme, for a purpose of its own. On the day of dealing it may have been above what the holder got or below it, and the transaction did not happen at it either way.

So the difference between the two, measured on the day the holder actually dealt, belongs to that holder, in whichever direction it happened to fall. A sale when the traded price sits below the computed value brings in less than the units were worth; that shortfall did not come out of the scheme's assets and was not charged to the other holders. It sat with the seller. A purchase when the traded price sits above the computed value costs more than the units were worth, and again the amount sat with the holder. There is no third party quietly absorbing it.

What does the holder pay that appears in no expense ratio?

The difference between price and value, and nothing on any document records what it was. The amount is real: it is the gap between the price transacted at and what the units were worth at that moment, multiplied by the number of units dealt in. It has a rupee value on the day. Never having been a charge levied by anybody, the amount appears in no expense ratioThe running charge a scheme takes against its own assets, quoted as a percentage of assets a year., in no statement of expenses, and in no annual figure of any kind. The difference was simply the terms of a transaction between two holders.

The amount also cannot be signed in advance. A charge is always a subtraction. A distance is not, and which side of the value a holder lands on depends on the day and the direction of the transaction. A holder who bought on a day when the price sat below the value came out ahead of the value, and that too appears nowhere.

Which is why setting an exchange traded scheme beside any other scheme on the printed charge alone leaves out a cost that only exists in this structure at all. The comparison is not wrong because the printed figures are wrong. The comparison is incomplete because one of the two structures has a second cost line that never gets printed, and comparing complete against incomplete produces a conclusion neither figure supports.

Does an exchange change how the scheme's own charge is taken?

Not in the slightest, and that is the reassuring part of the structure. The scheme's charge accrues against the portfolio every single day, exactly as it does in any other scheme. The computed value is struck after that accrual, so it carries the charge in the ordinary way, and no holder is ever asked to pay it separately.

Put a number on it with the figures the two schemes supply. The Girnar Broad Market Index Fund charges 0.20 per cent a year of that scheme's own assets. For every Rs 1,00,000/- of the scheme's assets that is Rs 200/- across the year. Spread across 365 days, Rs 200/- is about Rs 0.5479 a day. Check it backwards: Rs 0.5479 multiplied by 365 gives Rs 199.9835, a shade under Rs 200/-. The daily figure was rounded down at the fourth decimal place, so the true daily amount is very slightly larger. A real charge is struck on assets that move, so holding the base constant at Rs 1,00,000/- is an assumption rather than a fact about the scheme.

For contrast, the Girnar Large Cap Equity Fund charges 1.65 per cent a year of its own assets. On the same Rs 1,00,000/- base that is Rs 1,650/- a year, about Rs 4.5205 a day, again rounded down at the fourth decimal. The two schemes are different in kind, one actively managed and one following a rule, and setting the two charges beside each other ranks nothing about either approach. Whatever the charge is, and whichever structure carries it, it accrues against the portfolio day by day, so an exchange changes where a holder transacts and changes nothing at all about how the scheme is charged.

What does a holder of exchange traded units actually hold?

Units of the scheme. The answer is much less exotic than the machinery around it suggests. The claim that results is the same kind of claim any pooled scheme issues: a proportionate interest in one pool of holdings, rising and falling with what that pool is worth, carrying the scheme's charge in the ordinary way.

Only the place where the units are recorded differs. Exchange traded units are held in dematerialisedHeld as an electronic record with a depository rather than as a paper certificate or as a folio entry at the scheme's registrar. form. A holder therefore needs an account of that kind before they can hold or transfer them at all. The requirement is real and worth knowing in advance. Any charge for such an account, the providers that offer one and the conditions attaching to it are matters for the depositories. The dematerialised holding of units is described by National Securities Depository Limited (NSDL) at nsdl.co.in and by Central Depository Services India Limited (CDSL) at cdslindia.com.

So what changed is the counterparty and the place, not the thing finally held. A reader who pictures exchange traded units as a different species of instrument will keep looking for a mechanism that is not there. A reader who pictures them as ordinary scheme units with a second venue attached will answer every question here correctly.

What happens when a real tracker's shortfall is sorted against this structure?

Something clarifying, and it works precisely because the scheme in question is not exchange traded. The Girnar Broad Market Index Fund is an index fund following an unnamed broad index, and it is not exchange traded. The scheme serves to isolate what an exchange would and would not change, rather than to stand as an example of one.

For the stated year that scheme returned 12.12 per cent net, measured after its own charge, against 12.40 per cent for the index it follows. An index is not investable and nobody pays anything to hold it, so the index return carries no costs at all. A net figure is therefore being set against a costless one, and the bases have to be named every time. Work the split rather than reading it off.

The two checks matter. A perfect tracker charging 0.20 per cent would have returned 12.20 per cent for that year, and the scheme returned 12.12 per cent, so it fell 0.08 points short of even that. The residual has arrived by a second route. And adding 12.12, 0.20 and 0.08 returns exactly 12.40, so nothing has been lost in the split. Since 0.28 is seven times 0.04 while 0.20 is five times it and 0.08 is two times it, the 0.20 points is exactly five sevenths of the 0.28 and the 0.08 points is exactly two sevenths of it. As percentages of the shortfall those are about 71.4 and about 28.6. Both are approximations of exact fractions rather than figures in their own right.

The 0.08 points is not a rounding leftover. The 0.08 points is cash the scheme holds rather than invests, the timing of money arriving and leaving, and the cost of dealing when the index itself changes. Now sort all three items against the structure, one at a time.

Measuring how much of the 0.08 points would move needs an exchange traded scheme to measure it against, and Girnar Asset Management runs none, so no share of the residual is re-assigned above and no figure is put on the change. Saying that plainly is the difference between teaching a structure and inventing a result. The sorting is what survives: one cost is untouched by an exchange, one changes hands, and one exists only because of the exchange. A number attaches to the first and to neither of the other two.

Which quantities exist only once a scheme is exchange traded?

Five of them, and not one of the five can be given a figure by either scheme above. Girnar Asset Management Limited runs an actively managed equity scheme and an index fund, and neither is exchange traded.

The five are these: what a unit last changed hands at, what a unit was worth at that same moment, the distance between those two, what it costs to deal in the units, and the size of a block dealt with the scheme. Not one of the five carries a figure above or in any drawing. The two prices in the drawings are marks rather than numbers for that reason.

A worked distance feels more complete, so the temptation to fill those boxes is strong. Filling them would be teaching from a number nobody measured, dressed in the authority of a diagram. An empty box that says it is empty is worth more than a plausible one.

Girnar Asset Management Limited, the Girnar Large Cap Equity Fund, the Girnar Broad Market Index Fund, the unnamed broad index, Kalyani Bhagat and Sohail Merchant are invented.
Educational material. Not advice on any investment, tax, budget or market position.