Case 057Index funds, ETFs and passiveWarm up

The bank ETF of Tejasvi Mutual Fund shows a 0.8% bid-ask spread and only Rs 40 lakh of daily volume, so a client calls it illiquid. Its 12 underlying bank stocks trade Rs 4,000 crore a day. Is the ETF illiquid, and how should the client place a Rs 30 lakh order?

The situation

Tejasvi Mutual Fund runs an ETF that tracks an index of 12 large listed banks. On the exchange screen the ETF trades about Rs 40 lakh a day, and at the moment the best buy and sell quotes are 0.8% apart. The 12 bank stocks inside the index trade about Rs 4,000 crore a day between them, with spreads of a few hundredths of a per cent.

A wealth client wants to invest Rs 30 lakh. Looking at the screen, the client says the ETF is illiquid and asks whether to buy the bank stocks directly instead. You are on the passive team that supports distributors.

Your task

Is the ETF illiquid, what would a careless order cost, and how should the client place the Rs 30 lakh order?

Quick check

What mainly limits how much of this ETF can be bought at a fair price?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The ETF is not illiquid; its screen is quiet. Its real liquidity is the basket of 12 bank stocks trading Rs 4,000 crore a day, which market makers tap to create units. A market order crossing a 0.8% spread costs about Rs 12,000 on Rs 30 lakh. A limit order near the indicative NAV, placed in mid-session or through the AMC's market makers, should cost a fraction of that.

Step 1Why does low screen volume not mean the ETF is illiquid?

Imagine a bakery counter with only three loaves on display. It looks as if you cannot buy twenty, but the kitchen behind it bakes to order. An ETF's screen is the display; the kitchen is the creation process, in which a market maker buys the underlying shares and swaps them with the AMC for new ETF units. If more buyers arrive, more units are made. So what matters is how easily the market maker can buy the 12 bank stocks, and they trade Rs 4,000 crore a day.

Put the order against both layers. Rs 30 lakh is 75% of a day's volume on the ETF screen, which sounds alarming. It is 0.0075% of a day's trading in the basket, which is nothing. The second number is the one that decides whether the order can be filled at a fair price.

Where an ETF's liquidity actually comes fromLayer 1: the exchange screenRs 40 lakh traded a day, 0.8% bid-ask spreadWhat the client sees, and what looks illiquidMarket makers and the AMCcreate or redeem ETF unitsLayer 2: the basket of 12 bank stocksRs 4,000 crore traded a dayWhat actually limits how much can be tradedsell new unitsbuy unitsbuy the basketsell the basketA Rs 30 lakh order is75% of a day on the screen0.0075% of a day in the baskettoo small to draw at this scaleThe screen is a thin layer on top; the basket underneath sets the real capacity
Tejasvi's bank ETF trades only Rs 40 lakh a day on the exchange, but market makers can create units from a basket that trades Rs 4,000 crore a day, so a Rs 30 lakh order is 75% of screen volume and only 0.0075% of the basket's.
Step 2Then why is the spread 0.8%?

Because the quotes on the screen at any moment are only what the market maker chose to show. A wide quote can mean the market maker has stepped back for a few minutes, the market has just opened, or nobody has asked. The fair value of the ETF is its iNAVIndicative NAV: an estimate of the value of one ETF unit, recalculated through the trading day from the live prices of the basket., which the exchange publishes during the day. The spread a market maker needs is roughly the cost of trading the basket plus a small margin, which for liquid bank stocks is about a tenth of a per cent, not 0.8%. The quoted 0.8% is an offer to the careless, not the true cost.

Step 3How should the client place the order, and what does it save?

A market order buys at the offer, 0.4% above the middle of the spread: Rs 12,000 on Rs 30 lakh, and more if it eats through thin quotes. A limit order set close to the iNAV, at about 0.05% above it, costs about Rs 1,500. The method of placing the order, not the ETF, decides whether the client pays Rs 12,000 or about Rs 1,500.

How the Rs 30 lakh order is placedPrice paid against fair valueApproximate cost, Rs
Market order against the 0.8% quote+0.40%12,000
Limit order near the iNAV, mid-session+0.05%1,500
Buying the 12 stocks directly12 orders to weight and rebalanceSpreads small, effort and drift large
On Rs 30 lakh, crossing the 0.8% quoted spread costs about Rs 12,000, while a limit order near the indicative NAV costs about Rs 1,500, which is why the order type matters more than the screen volume.

The practical steps: avoid the first and last minutes of the session, when quotes are widest; place a limit order a little above the iNAV and let the market maker fill it; and for a larger order, ask the AMC to connect the distributor with its appointed market makers, who will quote for size. Very large investors can transact directly with the AMC in creation unit size; confirm the current threshold and rules, which SEBI has revised over time. Buying the 12 banks directly is possible, but the client then has 12 positions to weight and rebalance for no saving.

Where candidates lose it

Candidates accept the client's framing and compare the ETF's Rs 40 lakh of volume with the Rs 30 lakh order. That measures the display, not the stock room, and leads to the wrong advice to avoid a product that is perfectly fit for the order.

The other miss is ignoring the order type. Saying the ETF is liquid and leaving the client to place a market order into a 0.8% spread loses money the answer was meant to save.

What the interviewer asks next

  • When would an ETF genuinely be illiquid even though its basket is liquid?
  • What does it mean when an ETF trades at a 2% premium to its iNAV for weeks?
  • Would you suggest the index fund instead of the ETF for this client? What changes?

Company names and figures are illustrative.