Exchange-traded funds (ETFs) have captured the imagination of Indian investors with a powerful promise: significantly lower fees. Marketing materials relentlessly compare their expense ratios of 0.05% to 0.15% against the 0.20% to 0.50% charged by traditional index mutual funds. This simple comparison makes ETFs appear as the undisputed, cost-effective champion.
However, this popular narrative tells only half the story. It focuses solely on the explicit, visible costs while completely ignoring a layer of implicit, hidden expenses built into the very structure of ETF trading. For the average retail investor in India, especially those making regular investments, these hidden costs can often negate the advertised fee advantage, making the supposedly cheaper option more expensive in reality.
The Illusion of the Low Expense Ratio
The expense ratio is the annual management fee charged by the Asset Management Company (AMC). On paper, the math seems irrefutable. An ETF with a 0.05% expense ratio clearly undercuts an index fund charging 0.25%, offering a 0.20% annual saving. This is the figure prominently displayed and compared.
Yet, the total cost of owning an investment includes both these explicit fees and the implicit costs incurred during every transaction. For mutual funds, the transaction is straightforward with the fund house. For ETFs, these hidden costs surface each time you buy or sell units on the stock exchange, a mechanism fundamentally different from mutual funds.
The Real Cost of Buying and Selling ETFs
When you invest in a mutual fund, you transact directly with the fund house at the day's Net Asset Value (NAV). If the NAV is ₹100, you pay exactly ₹100, and your entire capital is deployed into the fund's portfolio. The AMC guarantees this liquidity.
ETFs operate on a different principle. The AMC does not sell units directly to you. Instead, it creates large blocks of units for entities known as Authorized Participants (APs). You, the retail investor, must buy these units from other sellers on the open market. This introduces a critical and often overlooked cost: the bid-ask spread.
Understanding the Invisible Bid-Ask Spread
Since the AMC is not a direct counterparty, market makers and APs provide liquidity. They constantly quote two prices on the exchange: a bid price (what they'll pay to buy from you) and an ask price (what they'll charge to sell to you). The gap between these two prices is the bid-ask spread, a transaction cost invisible in the expense ratio.
Consider an ETF with a true NAV of ₹100. The market quote might show a bid of ₹99.50 and an ask of ₹100.50. To buy, you pay ₹100.50 for an asset worth ₹100. When you later sell, you receive only ₹99.50. Across this buy-sell cycle, you have lost ₹1, which represents a 1% total cost on your investment, paid directly to the liquidity provider.
This spread exists because APs are profit-seeking entities. They facilitate the creation and redemption of ETF units to keep its market price aligned with NAV. When demand is high and the ETF trades at a premium (e.g., ₹105 vs. NAV of ₹100), an AP can buy the underlying stocks, create ETF units, and sell them to you at the higher price, pocketing the difference. This premium acts as a hidden entry load. The reverse happens during sales at a discount.
Who Really Benefits from the ETF Structure?
It's crucial to understand that the ETF structure was primarily designed to solve a liquidity problem for institutional investors and fund managers, not to save costs for retail investors.
In a mutual fund, large redemptions force the fund manager to sell holdings, incurring costs that impact all investors. In an ETF, when you sell, you trade with another buyer on the exchange; the fund's portfolio remains untouched. This transfers the liquidity burden from the AMC to the market, benefiting the fund manager and long-term holders but passing the transaction cost (the spread) directly to the individual buyer and seller.
Therefore, for a retail investor using a systematic investment plan (SIP) to make regular, small purchases, these cumulative bid-ask spread costs can easily outweigh the modest annual savings from a lower expense ratio. The guarantee of transacting at the exact NAV in an index mutual fund often results in a lower total cost of ownership, despite its higher stated fee.
In conclusion, smart investing requires looking beyond simplified marketing comparisons. While ETFs are powerful tools, their cost advantage is not universal. For the typical Indian retail investor committing funds monthly, a direct index mutual fund may frequently be the more cost-efficient choice when all implicit and explicit costs are factored in. Always base your decision on your specific investment pattern and a complete understanding of the cost structure.
