Exchange Traded Funds (ETF) are getting more popular. Ironically, many are not sure how they work. Here is a brief explanation.
An ETF is formed via a creation / redemption mechanism.
When an ETF issuer wants to create new shares of an ETF, it goes to an Authorized Participant (AP). An AP may be a market maker or a large financial institution.
The AP goes into the market and buys the underlying securities the ETF has to hold and delivers those securities to the ETF issuer. In return, the issuer gives the AP a block of ETF shares that can be sold in the open market.
It’s an in-kind transaction, securities for shares that is called a creation.
For example, if an ETF is to track the Nifty, the AP buys all the 50 stocks in the index in identical weights. The AP then delivers the 50 shares to the ETF provider. In return, the AP receives a "creation unit" – a block of equally valued ETF shares.
The process also works in reverse. When APs step into the market and buy ETF shares to return them to the ETF issuer. In exchange, they get the same value in underlying securities. That’s a redemption.
The creation/redemption mechanism allows APs to step in and create or redeem ETF shares. It allows ETFs to gain access to the market and keeps the share prices in line with its underlying holdings. Because they trade like stocks, the share prices fluctuate during the day, and when they deviate from net asset value, APs rely on the creation / redemption mechanism to bring ETF share prices back in line with fair value.
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Does an ETF resemble a stock?
An ETF allows you to buy and sell an entire index like a stock.
You can buy and sell ETF units on the stock exchange (secondary market). You can do so during trading hours. You will have to have a demat account to do so, and trade via a broker. This sounds like owning a stock.
The price of an ETF unit may be higher or lower than the Net Asset Value (NAV) as they are governed by supply and demand among the ETF investors (in the secondary market). If there is a big difference between the price of the unit and its NAV, you can lose or gain when you transact.
There is a finite supply of stocks, so large trades could drive up its price. On the other hand, the supply of ETF units is flexible. They can be increased or decreased based on demand. If there is more demand, the fund house will contact the APs and create more units. This helps reduce the impact of large trades.
Does an ETF resemble an index fund?
Yes, both are targeted at passive investors. Both are designed to reflect the relevant index.
The biggest difference between ETFs and index funds is that ETFs are listed on the stock exchange and can be traded throughout the day like stocks, whereas index funds can be bought and sold only at the NAV set at the end of each trading day.
Hence, you need a demat account to buy and sell ETFs, but do not need it to buy and sell the units of an index fund.
Worth noting is that listed stocks, index funds and other mutual funds do not use APs.
