Exchange Traded Fund (ETF)
An Exchange Traded Fund (ETF) is a basket of securities pooled together to create a marketable security that tracks a collection of assets, bonds, commodities or a stock index. ETFs are similar to mutual funds, the major difference being that they trade on an exchange just like stocks do. Prices of ETF’s shares fluctuate just like stocks do as buyers and sellers transact. A lot of the large ETFs that track market indices are highly liquid with large volumes of shares transacted daily. They also charge lower fees than mutual funds making them a suitable investment for most individual investors.
ETFs are created in various structures. They can be designed to track an index, bonds, a sector, commodities, foreign markets or even the strategy of a particular portfolio manager. ETFs are registered with market regulators. For instance, ETFs in the US are registered and regulated by the Securities and Exchange Commission (SEC).
They provide investors with a way to bring their money together in a fund that invests in stocks, bonds, commodities, alternative assets or a particular active strategy. The individual investors get a portion of the investment pool.
ETFs are a bit different from mutual funds. They do not sell their shares or redeem them directly from retail investors. ETFs can be bought and sold on many stock exchanges where they are traded like normal stocks during market hours. Trading is done at market prices that fluctuate just like stocks do. The price they trade at can be above or below the Net Asset Value (NAV) of the underlying securities.
ETF Share Creation and Redemption
ETFs shares are supplied through a controlled process referred to as creation and redemption. Authorized Participants (APs) who are large banks and financial institutions are the only ones allowed to participate in the process of purchasing and redeeming shares. ETF sponsors have contractual agreements with single or multiple authorized participants.
An Authorized Participant redeems shares in an ETF by selling them to the sponsor. This is done in large blocks of shares of about 50,000 which are typically called creation units. On the other hand, creation involves selling of stocks, bonds and alternative assets by the authorized participants to the ETF sponsor in exchange for shares in the ETF. They exchange the ETF shares they buy with a pool of securities or alternative assets that mirror the ETF’s holdings. When the banking institution or large blocker receives a chunk of ETF shares, they are permitted to unload them by selling them in the secondary market to willing investors.
Creation and redemption of ETF shares are determined by the demand of the ETF in the market. Another factor that influences this is whether the ETF is trading at a premium or discount to its net asset value. Usually, an ETF trades at a discount when it’s market price is lower than the value of its holdings. On the other hand, it is said to be trading at a premium when the price on the market exceeds the value of the ETF’s holdings. All ETFs are required to maintain the premium discount historical data on their respective website or that of their sponsor. They are also required to maintain the ETFs prospectus document. Just like a mutual fund does, an ETF is required to calculate its Net Asset Value (NAV) at least one time in a day.
Common Features of ETFs
Some of the common characteristics of ETFs are listed below
- Professional Management: A majority of ETFs are managed by SEC-registered investment advisers.
- Diversification: ETFs that hold a wide range of companies or track a stock index with a huge number of stocks are an effective diversification tool. They enable investors to achieve diversification by owning a few ETFs rather than selecting a basket of stocks and bonds.
- Low Minimum Investment: ETF shares can easily be bought on the market for just a few dollars.
- Trading & Liquidity Convenience: ETF investors can buy and sell ETF shares at any time when the market is open.
- Costs despite Negative Returns: ETFs must pay annual fees, management fees, brokerage fees and other expenses regardless of performance.
- No Control: Investors in an ETF cannot select the securities an ETF holds. This denies the investor the level of control they would have in their own personal portfolio.
In conclusion, ETFs are one of the most important investment products invented for investors in the recent past. They are great investment vehicles that provide liquidity and diversification. ETFs have also provided investors with access to asset classes that were hard to invest in the past especially for individual investors.