An exchange-traded fund is an investment fund, similar to a mutual fund, which is pegged to a financial index. Unlike mutual funds, which are priced once in a day, an exchange traded fund trades on exchanges throughout the day, just like stocks.

ETFs first came into operation in 1993 and, since then, have grown in popularity as an investment tool. They are passively managed, i.e., there is no fund manager.

ETFs are hybrid products that have the characteristics of a mutual fund as well as common stocks. An investor buys proportional shares to be part of the investment pool as in mutual funds. ETFs are managed by an investment advisor for a fee, similar to mutual funds. Like common stocks they can be traded in markets globally on a continuous basis. They have a continuous pricing and liquidity and can be bought and sold through brokerage accounts.

The main advantages of ETFs are access to all asset classes, hitherto available only to large institutional investors. This includes emerging market funds as well. Investors can include several investment strategies including different asset classes.

The transparency of ETFs is high and investors are clear about the elements in their ETF. The price and liquidity of ETFs is high and therefore investors value it over several other investment instruments.

ETFs also ensure tax fairness and tax efficiency. They have higher tax- efficiency because of lower portfolio turnover and in-kind redemptions. They offer securities in redemption, rather than cash. This helps avoid taxability.

Types of ETFs

There are several types of ETFs:

• Diversified passive ETFs: mirrors the performance of S&P 500, Dow Jones Industrial Average, and the MSCI exchanges.
• Fixed- income ETFs: these ETFs focus on bonds and have a stable portfolio.
• Niche passive equity ETFs: as the name suggests it is a basket of more closely chosen smaller companies in indexes.
• Active equity ETFs: these funds are chosen and managed by the fund advisor, rather than following any particular index. They have the probability of outdoing the market but there is also a risk of underperforming.

ETFs use a creation/ redemption mechanism that allows them to be more tax-efficient, transparent and less expensive than mutual funds. Let’s take a look at how this works.

Creation of ETFs

The Authorized Purchaser or AP buys a creation basket that contains the underlying securities of the ETF in the secondary market or stock exchange. They then deliver the creation basket to the exchange traded fund. The AP then gets the new ETF shares which they go to sell on the stock market.

Redemption of ETFs

The Authorized Purchaser (AP) buys the shares of ETFs from the stock exchange. They then deliver the ETF shares to the fund. The AP receives the portfolio of the ETFs underlying securities. The AP sells the ETFs underlying securities in the stock exchange.

An authorized purchaser is usually a financial institution or market specialist who has high purchasing power. They help acquire the shares the ETF wants to hold. The AP buys shares in the same weights as the index and delivers them to the ETF provider. The ETF provider gives the AP a creation unit, a block of equally valued ETF units which contain blocks of 50,000 units. This is a fair value exchange based on Net Asset Value or NAV. The AP can resell the shares for profit.

The redemption process works in reverse where the AP can purchase ETF shares from the market, generate a creation unit and sell it to the ETF provider. APs can then avail underlying securities of the fund of the same value.

This creation/redemption process that happens on a continuous basis ensures that ETF share price does not rise above the underlying securities in the fund. The same is true if the ETF starts to fall below the value of the underlying securities. This process is a calibrating mechanism to keep the ETF at its optimum.

It is an efficient way to access the market and allows for more trading maneuverability. Since only APs purchase and sell the shares, the time taken to do so is lesser and there is no distribution of commissions or brokerage charges. APs pay all the fees and costs and cover the cost of buying and redemption paperwork for the ETF provider as well.

Risks of ETFs

ETFs are not without risks and it is important to understand them before trading in them.

• Market risk: ETFs are sensitive to market ups and downs.
• Quality of picks: The quality of underlying securities in the same sector may differ from fund to fund. It is prudent to research which shares are in the index.
• Exposure to exotic risk: ETFs open the market to more complex and exotic investment instruments. It is important to research these instruments before investing in them.
• Check for tax treatment: ETFs are tax efficient but it is also important to check if there are capital gains to be paid beyond a specified holding period.
• Shutdown risk: All ETFs do not perform well and some are liquidated and are redeemed in cash. However, the fund may do so after deducting transaction costs and other overheads.
• Liquidity risk: ETFs do not come with zero transaction costs. Trading costs can lower your returns and therefore liquidity. Research well before investing.

Learn more about ETFs and how they are valued.