Two Nifty 50 ETFs sit on the same screen. One charges five basis points a year, the other seven. The investor picks the cheaper one, feels diligent, and buys it on a fund whose order book is a per cent wide.
The two-basis-point saving is worth ₹20 a year on a ₹1 lakh holding. The spread cost them ₹500 on entry and will cost roughly ₹500 again on exit. They have optimised the small number and ignored the one that is fifty times larger.
This is the single most common error in Indian ETF investing, and it is entirely avoidable by looking at one panel before buying.
The costs you can see and the costs you cannot
The expense ratio is published, standardised and easy to compare. That is exactly why it receives attention out of all proportion to its size.
The costs that actually vary between two funds tracking the same index are:
- The bid-ask spread, paid on entry and again on exit.
- The impact cost of your own order walking up the book.
- The premium or discount to NAV at the moment you transact.
None of these appear in a factsheet. All of them are visible in the order book on the fund's page, and all of them are functions of one underlying variable: liquidity.
Visible liquidity versus real liquidity
Here is where Indian ETFs differ from stocks, and where the standard advice goes wrong.
For a stock, the order book is essentially the whole story. There is a fixed float, and what is on screen is what you can trade against.
For an ETF, there is a second layer. Authorised participants — large institutions with a direct relationship with the AMC — can create new units by delivering the underlying basket, or redeem units by taking the basket back. When the ETF price drifts far enough from NAV, that arbitrage becomes profitable and they step in, which pushes the price back toward fair value.
This means an ETF's real liquidity is anchored to the liquidity of what it holds, not only to what is displayed on screen. A Nifty 50 ETF with a modest visible book is underwritten by the fact that the fifty underlying stocks are among the most liquid instruments in the country.
Two consequences follow, and they point in opposite directions:
- On broad-index ETFs, the screen understates your true liquidity. The mechanism is economic and it works.
- On narrow, thematic or small ETFs, the screen is roughly all there is. If the underlying basket is itself illiquid, or the fund is too small for the arbitrage to be worth an institution's time, nobody is coming to help.
The failure mode is assuming the first case applies when you are actually in the second.
Reading the depth ladder properly
The Depth and liquidity panel on each fund's page is the primary evidence. Read it in this order.
Spread first. Take the best bid and the best offer and express the gap as a percentage of the price. Under about 0.1 per cent is comfortable for a broad-index fund. Approaching or exceeding one per cent, you are paying a meaningful toll every time you transact.
Depth second. Look at the quantity available at each level, not just the top. The question is whether your intended order size can be absorbed within the first two or three levels. If it cannot, your realised price will be worse than the quote you are looking at — and the ladder is telling you by exactly how much.
Balance third. Compare the bid side against the offer side. A book with substantial offers and almost nothing bid means the fund is easy to enter and hard to leave. For a long-term holding, exit liquidity is the one that eventually matters.
The four questions before you buy any ETF
- Is the spread under a tenth of a per cent? If yes, proceed. If it is approaching a per cent, this fund needs to be materially better on some other dimension to justify the toll.
- Can the visible book absorb my order? If not, split the order across sessions or use a limit price and wait.
- How far is price from NAV? The Price vs NAV stat answers this. A persistent premium means you are subsidising other people's enthusiasm.
- Does the chart show every session trading? Gaps and flat stretches mean days when you could not have exited at all.
Four checks, one screen, under a minute. Compare that against the time people spend comparing expense ratios.
Why the largest fund usually wins
Between two ETFs on the same index, the larger one is normally the better buy, even at a slightly higher expense ratio. Size is self-reinforcing:
- More assets support tighter market making.
- Tighter spreads attract more volume.
- More volume makes the creation-redemption arbitrage economic.
- Working arbitrage keeps price near NAV.
A small fund runs the same loop in reverse. It can also be wound up or merged, which forces an exit on a timetable you did not choose.
The threshold to apply is not a precise number but a behaviour: would this fund still be tradeable in a bad week? Liquidity is abundant when nobody needs it and vanishes when everybody does. The fund that is thin on a calm Tuesday will be untradeable on the morning you actually want out.
Order discipline
Liquidity analysis is worthless if you then send a market order into a thin book.
- Use limit orders. On anything outside the largest handful of funds, this is not a preference, it is the rule. A market order accepts every price the ladder is showing you, and on a thin fund those prices get ugly fast.
- Avoid the open and the close. Spreads are widest in the first and last few minutes. The middle of the session is where the book is most honest.
- Split large orders. If your size exceeds visible depth, work it across sessions rather than paying to clear the ladder in one go.
- Never chase. If the price has run away from NAV, the discipline is to wait. The index will still be there tomorrow.
The connection to everything else
Illiquidity is not an ETF-specific problem. It is the same failure that catches people in thin small-caps surfaced by a screener sorted by percentage gain, and the same one that catches them at far out-of-the-money strikes on an option chain.
The pattern repeats: an attractive-looking price that cannot be transacted at anything close to the number displayed.
For a deeper read on the fields involved, see how to read an ETF page. For the wrapper decision itself, see ETF vs mutual fund — and note that if the ETF you want is genuinely illiquid, the corresponding index fund sidesteps the entire problem by transacting at NAV.
That is often the right answer, and it is worth reaching for more readily than most people do.