Why ETFs aren't always cheaper than index mutual funds

Exchange-traded funds (ETFs) have gained popularity in India on a simple value proposition: lower expense ratios. The marketing emphasises expense ratios of 0.05-0.15% compared to 0.20-0.50% for equivalent index mutual funds. The savings appear straightforward and compelling.

This narrative focuses exclusively on explicit costs visible in fund documents while ignoring implicit costs embedded in the ETF structure itself. Understanding these hidden costs reveals why ETFs may not always deliver the cost advantage they advertise, particularly for retail investors making regular investments.

The Expense Ratio Tells Only Part of the Story

Expense ratios represent the annual fee charged by the Asset Management Company (AMC) for managing the fund. An ETF with a 0.05% expense ratio and an index mutual fund with a 0.25% expense ratio show a clear 0.20% annual cost difference favouring the ETF.

However, total ownership cost comprises both explicit costs, like expense ratios and implicit costs incurred during transactions. For ETFs, these implicit costs materialise every time you buy or sell units on the exchange.

How You Buy ETFs Creates Hidden Costs

The fundamental difference between mutual funds and ETFs lies in the purchase mechanism.

• Mutual Funds: You buy units directly from the fund house at the NAV. If the NAV is ₹100, you pay exactly ₹100. Every rupee you invest gets deployed fully into the fund. The fund house guarantees this liquidity, allowing you to transact at NAV regardless of market conditions.
• ETFs: The AMC does not sell units directly to retail investors. Instead, they create large blocks of units and provide them to Authorized Participants. You purchase units from other investors on the stock exchange, not from the fund house.

This exchange-based trading introduces a cost structure absent in mutual funds.

Understanding the Bid-Ask Spread

Since the AMC doesn’t provide direct liquidity, Authorized Participants (APs) or market makers handle this function. These entities constantly quote two prices on the exchange:

• Bid Price: The price at which they will buy ETF units from you.
• Ask Price: The price at which they will sell ETF units to you.

The difference between these prices is the bid-ask spread. You pay this spread every time you transact. When buying, you pay the higher ask price. When selling, you receive the lower bid price. This spread functions as an invisible transaction cost that doesn’t appear in any expense ratio calculation.

Consider an ETF with a NAV of ₹100. The bid-ask spread might show:

• Bid Price: ₹99.50
• Ask Price: ₹100.50

When you buy, you pay ₹100.50 for an asset worth ₹100. When you sell, you receive ₹99.50 for an asset worth ₹100. You’ve lost ₹1 in total through two transactions, representing a 1% cost on your investment.

Why This Spread Exists: The Creation and Redemption Mechanism

To understand why bid-ask spreads always exist, you need to understand how ETFs provide liquidity.

APs are large broker-dealers or market makers officially appointed by the AMC. Their primary function is acting as the link between the ETF issuer and the stock exchange, keeping the ETF ecosystem liquid and preventing large deviations between the ETF’s trading price and its underlying value.

Creation of Units: When demand for an ETF increases, the AP buys the underlying basket of securities. For a Nifty 50 ETF, this means purchasing all 50 stocks in the correct weightage. They transfer this basket to the AMC, which issues a large block of ETF units called a Creation Unit to the AP. The AP then sells these units on the exchange to meet investor demand.

Redemption of Units: When selling pressure increases, the AP buys ETF units from the exchange, accumulates them into a Creation Unit size, and returns them to the AMC. The AMC returns the underlying basket of securities or cash equivalent to the AP.

This mechanism keeps the ETF price aligned with its NAV. However, APs are profit-seeking entities, not charitable liquidity providers.

How APs Profit From You

APs make money from the bid-ask spread. If an ETF trades at ₹105 while the NAV is ₹100, an AP can buy the underlying stocks for ₹100, convert them to ETF units through the creation process, and sell those units to you at ₹105. They pocket the ₹5 difference.

You’ve just bought an asset worth ₹100 for ₹105. This 5% premium functions as a hidden entry load, despite ETFs being marketed as load-free investments.

The reverse happens when you sell. If the ETF trades at ₹95 while the NAV is ₹100, you sell to the AP at ₹95. They redeem those units with the AMC, receive the underlying basket worth ₹100, and profit from the ₹5 difference.

This isn’t market manipulation. It’s how the ETF structure incentivises APs to provide liquidity. But the cost falls entirely on you as the retail investor.

Why ETFs Were Designed This Way

The ETF structure wasn’t created to make investing cheaper for retail investors. It was designed to solve institutional investors’ and fund managers’ liquidity problems.

The Mutual Fund Problem: When you redeem ₹1 crore from a mutual fund, the fund manager must sell ₹1 crore worth of stocks to create liquidity. This incurs transaction costs, market impact costs, and potential capital gains taxes inside the fund. These costs affect all remaining investors, not just the person redeeming.

The ETF Solution: When you sell ETF units, you trade with another buyer on the exchange. The fund manager does nothing. The underlying portfolio remains untouched. No transaction costs burden other investors. The structure transfers liquidity management from the AMC to the marketplace.

This benefits the fund manager and long-term institutional holders. It does not necessarily benefit you as a retail investor making regular purchases.

Conclusion

Marketing emphasizes what’s easily comparable in a table, like expense ratios. It downplays what’s harder to quantify upfront, as cumulative bid-ask spread costs over multiple transactions. Understanding the complete cost structure rather than accepting simplified narratives leads to better investment decisions aligned with your actual usage patterns.

For retail investors making regular small investments through SIPs, index mutual funds often deliver lower total costs despite higher expense ratios. The guarantee of transacting at NAV without bid-ask spreads outweighs the expense ratio difference.

Finology is a SEBI-registered investment advisor firm with registration number: INA000012218.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.