What’s the role of a market maker in ETFs, and how do they impact prices on volatile days?

July 9, 2024

If you keep even a casual eye on the markets, you couldn’t have missed the reaction on election results day, June 4, 2024. In fact, that entire week was chaotic in the markets, with significant volatility. At one point, the market dropped nearly 8% on the results day but came full circle, closing flat by the end of the week compared to the start. But, yeah, that’s the nature of markets.

While everyone was focused on the mainstream markets, ETFs (Exchange Traded Funds), which track a basket of stocks and are traded on the stock exchange, were also on a bumpy ride. The ups and downs in the prices of the underlying shares played a part in the volatility of ETF prices. Another key factor was the gap between the ETF price and its indicative net asset value (iNAV), which reflects the value of underlying securities on a real-time basis.

You might wonder why ETF prices diverge from their iNAV since they match the portfolio of a particular market index. This gap can be caused by various reasons, including supply-and-demand mismatch or liquidity issues. But on volatile market days, this gap could be very high.  

Role of the distributor

To understand why this happens, let’s take a slight detour. Imagine a local Kirana store and a distributor supplying shampoos. The distributor buys shampoos from the manufacturer and sells them to the Kirana store owner at a slight profit. The manufacturer, distributor, and store owner agreed that any unsold shampoos could be returned.

Say the price of the shampoo sold to the customer is Rs 100. The store maintains stock of the shampoo based on the weekly demand. When demand spikes, the store requests more shampoo from the distributor. The distributor then contacts the manufacturer to produce more shampoos. On the other hand, when customers return shampoos, the store sends them to the distributor, who in turn gives them back to the manufacturer. As long as this supply chain functions smoothly, the price remains stable at Rs 100, unless the manufacturer changes it.

Now, imagine a sudden event, like a lockdown, causing a surge in demand for shampoos. The distributor/manufacturer can’t meet this huge demand immediately (either due to funding issues or manufacturing bottlenecks) and delays the supply. Taking advantage of the shortage, the store owner might sell shampoos at Rs 110 (not at the original price of Rs 100), until the supply chain goes back to normal.

Role of the Market Maker

In the above instance, do you realize how important a distributor’s role is in maintaining price stability? Now, let’s get to the ETF market.

In the ETF space, an intermediary called a ‘market maker’ acts like a distributor. The mutual fund company is the manufacturer of units, and the stock exchange (accessed via a broker platform) is the store where you can buy and sell ETF units.

When there are enough buyers and sellers for an ETF on the exchange, market makers may not have a significant role. But, when there are more buyers for an ETF and no sellers on the exchange, the market maker interferes – buys more units from the mutual fund house to supply in the market. This helps to keep ETF prices aligned with their iNAV or the fair value. Conversely, when there are so many investors on the exchange who want to sell but not enough takers, the market maker buys the ETF units from investors, preventing steep price drops. After that, the market maker redeems the units with the AMC.

However, on highly volatile days, such as the stock market crash in March 2020 (COVID-19) and election results day in 2024, the market maker (distributor) finds it challenging to create and redeem units with the fund house in time.

When there’s unexpected demand, the market maker may face funding constraints to create new units with the asset management company. Similarly, when investors rush to sell, the market maker may not have enough funds to buy all the units from investors. When the market maker cannot act in time, the supply and demand dynamics on the exchange distort ETF prices from their iNAVs.

There’s one more thing —  during volatile days, some of the underlying stocks in an ETF could hit their circuit limits. This is a mechanism in which the trading of such stocks is halted to prevent large price movements in a very short period of time. When that happens, the market makers would be hesitant to create or redeem ETF units because of the uncertainty in stock prices or the inability to price the ETF correctly.  

These are the prime reasons why ETF prices are distorted from their iNAVs on highly volatile market days. To know more about the creation and redemption of ETF units, check out this article on Varsity.

iNav sources

Certainly, the Indian ETF ecosystem has been improving over the years, and efforts are being made by all players to make ETF pricing more efficient on such volatile days.

ETFs are a cost-effective way to invest in markets on a real-time basis. Generally, the impact of market volatility on ETF prices is temporary. Once the volatility comes down, the ETF price should adjust to reflect the underlying holdings’ value. However, it’s best that investors always compare the ETF price to its iNAV for any large deviation before placing any order, so as to avoid overpaying or selling at lower prices.

You can find the iNAV on AMC websites, the NSE stock exchange, and some broker platforms. iNAVs of equity ETFs are usually updated in real-time, while debt fund iNAVs are updated at least four times a day. For  ETFs on gold, silver, or international equity, there is no set frequency, but it will be updated as and when the latest data on underlying assets is available.  

(with inputs from Vishal Jain, CEO of Zerodha Fund House) 

Personal Finance, Varsity

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