ETF liquidity in India

An ETF is designed to be as liquid as any listed share — buyable and sellable all through the trading day. In practice, on Indian exchanges, that promise does not hold for most ETFs.

The workbook is blunt about it: except for a couple of ETFs, liquidity on Indian exchanges is very poor. There is often a big difference between what the fund's NAV says a unit is worth and what the market is actually quoting for it, and a relatively large gap between the buy and sell prices on offer.

An index fund, bought and sold directly with the AMC, does not have this problem — it always transacts at the official end-of-day NAV.

The workbook's comparison, on the "Liquidity" row for ETFs versus index funds:

ETF liquidity: depends on the market, and — barring a couple of exceptions — is very poor on Indian stock exchanges. Two specific symptoms are named: a big difference between the NAV of the underlying securities and the quoted market price, and a relatively large difference between the buy and sell quotes.

Index fund liquidity: available directly from the AMC on an end-of-day basis, so this thin-trading problem simply does not arise — every transaction happens at NAV, with the AMC on the other side of the trade rather than another market participant.

The underlying cause is low trading volume. When few buyers and sellers are actively quoting an ETF at any given moment, the market maker's spread widens to compensate for the risk of holding an unwanted position, and the traded price can drift away from where the ETF's actual NAV says it should be.

An investor wants to sell Rs 2,00,000 worth of units in a thinly-traded sector ETF. The ETF's official NAV, based on the value of its underlying holdings, is Rs 100 a unit. But on the exchange right now, the best available buy quote is only Rs 96 — a 4% discount to NAV, caused purely by weak trading interest rather than any change in the underlying portfolio's value.

Value at NAV:        2,000 units x Rs 100 = Rs 2,00,000
Actual sale proceeds: 2,000 units x Rs 96  = Rs 1,92,000
Loss purely from illiquidity                = Rs 8,000

Had the investor instead held the equivalent index fund, redeeming the same Rs 2,00,000 of exposure would have fetched the full NAV, with no such gap — because the transaction happens directly with the AMC, not against whatever price the exchange's thin order book happens to be quoting that moment.

Chapter 19 (Comparison of Products across categories), section 19.2.6, sets out this liquidity comparison directly, and the fund comparison tables elsewhere in the same chapter (section 19.2.7, physical gold versus gold funds versus gold ETFs) repeat the same theme for gold ETFs specifically. Expect a question asking why an ETF's market price can differ from its NAV, or a comparison question between ETF and index fund liquidity.

• "Listed and tradable all day" does not mean "liquid." The workbook explicitly separates the two — an ETF can be technically tradable throughout the day while still having very poor real liquidity.
• Only a couple of ETFs are named as exceptions to the poor-liquidity pattern — do not assume large fund size alone guarantees good liquidity on Indian exchanges.
• The NAV-versus-market-price gap and the wide bid-ask spread are two separate symptoms of the same underlying cause (thin trading), not two unrelated facts.
• Index funds do not have this problem, precisely because they are not exchange-traded — transacting directly with the AMC at NAV sidesteps market liquidity entirely.