They can be bought and sold throughout a trading day like any stock
An exchange-traded fund (ETF) is a basket of securities that are traded on an exchange. They first came into existence in the US in the early 90s. Initially, these were looked upon with suspicion. However, of late, these funds have been attracting the interest of investors globally.
ETFs are different from mutual funds. ETF units are not sold to the public for cash. Instead, the asset management company that sponsors the ETF takes the shares of companies comprising the index from various categories of investors like authorized participants, large investors and institutions. In turn, it issues them a large block of ETF units. In case any dividend is accumulated for the stocks at any point in time, a cash component to that extent is also taken from such investors. A large block of ETF units called a 'creation unit' is exchanged for a 'portfolio deposit' of stocks and the 'cash component'.
Unlike regular open-ended mutual funds, ETFs can be bought and sold throughout the trading day like any stock. These funds rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values (NAV) of their underlying portfolios. In order to let the mechanism work, the potential arbitragers need to have full, timely knowledge of a fund's holdings.
ETF units are continuously created and redeemed based on investor demand. Investors may use ETFs for investments, trading or arbitrage. The price of the ETF tracks the value of the underlying index. This provides an opportunity to investors to compare the value of the underlying index against the price of the ETF units prevailing on the exchange. If the value of the underlying index is higher than the price of the ETF, the investors may redeem the units to the sponsor in exchange for the higher priced securities.
In case the price of the underlying securities is lower than the ETF, the investors may create ETF units by depositing the lower-priced securities. This arbitrage mechanism eliminates the problem associated with close-end mutual funds - premium or discount to the NAV.
The number of outstanding ETF units is not limited, as with traditional mutual funds. It may increase if investors deposit shares to create ETF units, or it may reduce on a day if some ETF holders redeem their ETF units for the underlying shares. These transactions are conducted by sending creation or redemption instructions to the fund. The portfolio deposit closely approximates the proportion of the stocks in the index together with a specified amount of cash component. This 'in-kind' creation/redemption facility ensures that ETFs trade close to their fair value at any given time.
Due to the unique structure of ETFs, all types of investors, whether retail or institutional, long-term or short-term, can use it to their advantage without being at a disadvantage to others. They allow long-term investors to diversify their portfolio at one go at low cost and insulates them from short-term trading activity due to the unique 'in-kind' c re at i o n / re d e m p t i o n process.
They also provide liquidity to investors with a shorter-term horizon as they can trade intra-day and can have quotes near NAV during the course of a trading day. As the initial investment is low, retail investors find it simple and convenient to buy/sell. They facilitate foreign institutional investors, institutional buyers and mutual funds to have easy asset allocations and hedging at a low cost. They also enable arbitrageurs to carry out arbitrage between the cash and futures markets at low impact costs.
Most ETFs charge lower annual expenses than index mutual funds. However, you have to pay a brokerage to buy and sell ETF units. This may turn out to be a significant drawback for those who trade frequently or invest regular sums of money. Many investors prefer to hold the creation units in their portfolios. Others may break-up the creation units and sell on the exchanges, where individual investors may purchase them just like any other shares.
An exchange-traded fund (ETF) is a basket of securities that are traded on an exchange. They first came into existence in the US in the early 90s. Initially, these were looked upon with suspicion. However, of late, these funds have been attracting the interest of investors globally.
ETFs are different from mutual funds. ETF units are not sold to the public for cash. Instead, the asset management company that sponsors the ETF takes the shares of companies comprising the index from various categories of investors like authorized participants, large investors and institutions. In turn, it issues them a large block of ETF units. In case any dividend is accumulated for the stocks at any point in time, a cash component to that extent is also taken from such investors. A large block of ETF units called a 'creation unit' is exchanged for a 'portfolio deposit' of stocks and the 'cash component'.
Unlike regular open-ended mutual funds, ETFs can be bought and sold throughout the trading day like any stock. These funds rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values (NAV) of their underlying portfolios. In order to let the mechanism work, the potential arbitragers need to have full, timely knowledge of a fund's holdings.
ETF units are continuously created and redeemed based on investor demand. Investors may use ETFs for investments, trading or arbitrage. The price of the ETF tracks the value of the underlying index. This provides an opportunity to investors to compare the value of the underlying index against the price of the ETF units prevailing on the exchange. If the value of the underlying index is higher than the price of the ETF, the investors may redeem the units to the sponsor in exchange for the higher priced securities.
In case the price of the underlying securities is lower than the ETF, the investors may create ETF units by depositing the lower-priced securities. This arbitrage mechanism eliminates the problem associated with close-end mutual funds - premium or discount to the NAV.
The number of outstanding ETF units is not limited, as with traditional mutual funds. It may increase if investors deposit shares to create ETF units, or it may reduce on a day if some ETF holders redeem their ETF units for the underlying shares. These transactions are conducted by sending creation or redemption instructions to the fund. The portfolio deposit closely approximates the proportion of the stocks in the index together with a specified amount of cash component. This 'in-kind' creation/redemption facility ensures that ETFs trade close to their fair value at any given time.
Due to the unique structure of ETFs, all types of investors, whether retail or institutional, long-term or short-term, can use it to their advantage without being at a disadvantage to others. They allow long-term investors to diversify their portfolio at one go at low cost and insulates them from short-term trading activity due to the unique 'in-kind' c re at i o n / re d e m p t i o n process.
They also provide liquidity to investors with a shorter-term horizon as they can trade intra-day and can have quotes near NAV during the course of a trading day. As the initial investment is low, retail investors find it simple and convenient to buy/sell. They facilitate foreign institutional investors, institutional buyers and mutual funds to have easy asset allocations and hedging at a low cost. They also enable arbitrageurs to carry out arbitrage between the cash and futures markets at low impact costs.
Most ETFs charge lower annual expenses than index mutual funds. However, you have to pay a brokerage to buy and sell ETF units. This may turn out to be a significant drawback for those who trade frequently or invest regular sums of money. Many investors prefer to hold the creation units in their portfolios. Others may break-up the creation units and sell on the exchanges, where individual investors may purchase them just like any other shares.
