What are Exchange Traded Funds?
It is one of the most popular forms of investment because the investors get an access to a pool of undivided interest in securities and other investment opportunities similar to mutual fund investment. Basically an ETF is a mixture of a Mutual Fund and a Stock, because like mutual funds, they hold some specified stocks and an index like Sensex or Nifty and commodity like copper and gold, etc. Equity shares are traded in stock exchanges on real time basis.
Benefits of ETFs
- Can be traded in the stock market any time of the day when the market is open.
- Index funds can be purchased at the NAV based on the closing price.
- Short sale is permitted, It is possible to buy single unit or buy on margin that is impossible in the case of an index fund or conventional mutual funds
- Less expensive than MFs as running cost is less.
- Not solely depends on the fund manager
- They are very transparent like an index fund.
Disadvantages of ETFs
- For SIP in ETF you have to place fresh order every month and pay brokerage on every sell or buy order.
- Its conveniences forces people to trade more than actually they want.
- For reinvesting dividend you need brokers help and pay brokerage every time which is automatic without brokerage in MFs.
- Lack of understanding.
How Do They Work?
In ETF ‘Authorized Participants’ are appointed by the Asset Management Company (AMC), They take all the stock that build up the index and create ‘Creation Units’ with AMC. These creation units are in large blocks which are subsequently divided in small units that are sold in the stock market through APs.
If the demand rises the APs deposit more shares with the AMC to get more creation units. Conversely when there is more redemption they return these units to AMC to take back their shares sell them in the market to maintain liquidity. The process is very system based and acts on real time base with minimal effort and cost.