Chapter 11 · ETF Terms
ETF terms and the arbitrage behind them
NAV, AUM, expense ratio, tracking error and creation units — plus the mechanism that keeps an ETF's price near its NAV.
What you own when you own a fund
A fund pools money from many investors and buys a portfolio with it. You own units of the pool, not the shares inside it. An exchange-traded fund is a fund whose units trade on an exchange all session at a price set by buyers and sellers, rather than being bought from the fund at a once-a-day valuation.
The vocabulary, with the formula for each
| Term | What it is | Formula |
|---|---|---|
| NAV | The value of one unit | (Total assets − Liabilities) ÷ Units outstanding |
| AUM | The size of the fund | Σ market value of everything it holds |
| Expense ratio | Annual running cost, taken out of NAV daily | Annual costs ÷ Average AUM × 100 |
| Tracking difference | The plain gap to the index over a period | Fund return − Index return |
| Tracking error | How *consistent* that gap is | Standard deviation of (fund return − index return) |
| Premium / discount | How far the traded price sits from NAV | (Price − NAV) ÷ NAV × 100 |
| iNAV | An estimated NAV published through the session | Recomputed from live prices of the holdings |
| Creation unit | The block size the fund transacts in | Typically many thousands of units at once |
| Authorised participant | The institution allowed to create and redeem | Not a formula — a permission |
Worked: where the missing 1.4 points went
An index returns 14.0% over a year. The fund tracking it returns 12.6%. Its stated expense ratio is 0.5%.
- Tracking difference = 12.6 − 14.0 = −1.4 percentage points.
- The expense ratio explains 0.5 of that.
- The remaining 0.9 points came from somewhere else: cash sitting uninvested, the cost of rebalancing when the index changes, and holding a sample of the index rather than all of it.
- The expense ratio is not the cost of owning a fund. Tracking difference is. One is advertised; the other is measured.
The arbitrage — why an ETF price stays near NAV
Suppose an ETF trades at Rs 102 while the basket it holds is worth Rs 100 per unit. An authorised participant can buy the underlying shares for Rs 100, hand them to the fund, receive new units, and sell those units at Rs 102. Doing so adds supply, which pushes the price down toward Rs 100.
At a discount it runs the other way: buy cheap units on the exchange, hand them back to the fund, receive the shares, sell them. That removes supply and lifts the price. This mechanism, not goodwill or regulation, is what holds an ETF close to its NAV.
Kinds of ETF you will read about
- Index (passive) — holds the index, aims for zero tracking difference. The cheapest, and the large majority of assets worldwide.
- Active — a manager picks holdings inside an ETF wrapper. Higher expense ratio, and the tracking benchmark becomes a comparison rather than a target.
- Smart beta / factor — weights by something other than market cap: value, low volatility, quality, momentum. A rules-based middle ground.
- Sector and thematic — one industry or one idea. Concentrated by design, so the diversification an ETF normally gives you is largely gone.
- Bond, commodity and gold ETFs — same wrapper, different asset. Gold ETFs are the most common non-equity type globally.
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