A fund with its units listed
An exchange traded fund is a mutual fund whose units are listed. Everything from 01.06.01 still holds — it is a trust, the assets are held by a custodian, the NAV is still net assets divided by units. What changes is how you get in.
You do not send money to the fund. You place an order with your broker, it joins the order book you met in 01.04.01, and it matches against another investor who is selling. The units arrive in your alongside your ten Bharat Foods shares.
That should sound familiar, because it is 01.02.03 in new clothing: your money reaches whoever sold to you, not the fund. The scheme's pot does not grow because you bought. It grew when the units were created — and who creates them is the mechanism this lesson is really about.
So which number is the price?
There are three, and confusing them is the commonest mistake a new ETF buyer makes.
The NAV is what the scheme's holdings are worth, struck after the close, exactly as before. The indicative NAV — the iNAV — is the same calculation run through the trading day as the underlying shares move, so you can see roughly what the basket is worth at 11:04. The market price is what the order book says: the best bid, the best ask, and whatever last traded.
The first two describe the basket. The third describes the demand. Only the third is what you actually pay.
What the gap costs you
Drag the spread. This is the same panel as 01.03.03, because it is the same idea — an ETF just made it easier to overlook.
The basket is worth about ₹248.60 either way. Widen the spread and none of that changes — what changes is how much of your money never buys any of it. On a thin ETF the spread can be the largest single cost of owning it. You meet it twice — buying at the ask and selling at the bid — which over a round trip costs you one full spread, roughly half of it on each side of the middle.
The mechanism that holds the two together
If the market price can drift from the basket's value, what stops it drifting far? Not a rule. An opportunity.
Large institutions registered with the fund — authorised participants — may deal directly with the scheme, but only in big blocks called creation units. An authorised participant can hand the fund the underlying basket of shares and receive a block of new ETF units, or hand back a block of units and receive the basket.
Now watch what that makes possible. If the ETF trades above what the basket is worth, an authorised participant can buy the shares, exchange them for new units, and sell those units at the higher market price. That selling pushes the price down. If it trades below, the trade runs the other way and the buying pushes the price up. Nobody is being public-spirited — they are taking a profit, and the profit exists precisely because the gap does.
Creation, when the ETF is trading rich
The loop only runs while the gap is worth somebody's trouble.
Run it backwards for the opposite case: units bought cheap in the market, handed back to the fund, the basket sold. Either way the arbitrage removes the very gap it fed on — which is why a healthy ETF tracks its basket without anyone policing it.
An ETF's market price sits well above its iNAV all morning and nobody corrects it. What is the most likely explanation?
Tracking: two words that get swapped
A passive fund promises to follow an index. It never follows it exactly, and two different measurements describe the shortfall.
Tracking difference is the gap in return over a period — the fund returned this, the index returned that. It is mostly costs: the expense ratio from 01.06.01, the cash waiting to be invested, the price paid when the index rebalances on the schedule you saw in 01.05.04.
Tracking error is a different thing entirely: how much that gap wobbles from period to period. A fund can lag the index by a steady amount and have a small tracking error, because steady is exactly what tracking error measures the absence of.
You want to know both. A fund that trails predictably by its costs is doing its job. One that trails unpredictably is doing something you were not told about.
An ETF that barely trades looks illiquid, and people avoid it for that reason. But its real liquidity is the liquidity of the shares it holds — an authorised participant can create units against a liquid basket however quiet the screen looks. The trap runs the other way too, and it is the one that costs money: a quiet screen means the spread you personally pay is wide, whatever the basket could theoretically support. Check the spread before you check the volume. The spread is the bill you actually receive.
Two ETFs track the same index. One charges 0.05% a year but its spread is 0.50%; the other charges 0.20% and its spread is 0.05%. You buy once and hold for ten years. Which costs you more?
So a passive fund can be bought two ways: as units priced once a day from the fund itself, or as listed units priced continuously by whoever else wants them. Both hold the same rule-picked basket. What neither has yet explained is the harder question — why so much money has moved towards the rule and away from the manager.