What is an ETF?
An Exchange Traded Fund, or ETF, is a pooled investment that's like an investment fund, investing in potentially hundreds, sometimes thousands, of individual securities, but trades on an exchange throughout the day like a stock. When an investor buys an ETF share, he or she is buying a small percentage ownership of a large portfolio of stocks, bonds or other assets. It is basically an ownership stake in a pool of assets. ETFs allow a large number of investors to basically “share” in a larger, more diversified portfolio than they could assemble on their own.
What are the benefits of investing in ETFs?
ETFs provide a number of benefits, including the following:
- Buy & Sell at real time price
- ETF holdings or portfolio are readily disclosed, making your investment highly transparent
- Portfolio Diversification: ETFs provide exposure to the market through a basket of securities which results in portfolio diversification. They provide wide variety of sector, style, industry and country specific funds thereby giving a wide choice of diversification to the investors.
- Low cost: Low expense ratio resulting in lower cost
- Ideal for investors who want exposure to a number of securities, but through purchasing one share, units in ETF
What are different types of ETFs available for investments?
The different types of ETFs are:
Index ETF: Index ETFs are the type of ETFs whose unit value is derived from an index. The underlying index act as a tracking instrument. These ETFs seek to track the performance of an index by holding in its portfolio the contents of the index.
Commodity ETF: Commodity ETFs value is derived from commodities like gold, silver etc. For example, ETFS Physical Gold aims to track the price of gold and the units represent allocated physical gold which is kept in a vault with a custodian. These units are traded on the Exchange like a single stock of any company. ETFS Physical Gold ETF offer investors a means of participating in the gold bullion market without the necessity of taking physical delivery of gold.
International ETF: These ETFs have an international index like FTSE, as the underlying tracking instrument. The index chosen is often the major index within the country, designed to reflect the overall economic condition of the country.
Sector Specific ETF: These ETFs have a specific sector like energy, healthcare as the underlying tracking instrument. They closely track the performance of underlying sector & provide diversified exposure to your investments.
How is an ETF different from an investment fund?
ETFs offer investors intraday liquidity and can be bought and sold during the trading hours of the stock exchange. Investment funds are priced at the end of the day and cannot be bought or sold during regular trading hours. Thus, investors invest in real time prices as opposed to end of day prices. Also, ETFs are traded on a stock exchange, whereas investment funds are bought and sold directly with the fund company or through investment platform.
What are the risks associated with investing in ETFs?
ETFs are typically very cost efficient. However like other securities, every time an investor makes a purchase or sale they must pay brokerage costs. In addition the ETF investor can suffer from the usual costs of trading securities, such as differences in the bid-ask spread. This spread varies from one ETF to another. The same is neutralized by higher liquidity. Like all other investments related to markets, ETFs are also subjected to market risk which can be reduced by diversifying your investments across markets & sectors.
How is the market price of an ETF determined?
The market price of an ETF is usually very close to the market value of the underlying securities held in the portfolio, and any net income not distributed.
How liquid are ETFs?
All ETFs can be purchased or redeemed at any time while the exchange is open for trading. There is no limit to the holding period for an ETF.
How do I sell ETFs?
Investors sell ETFs like they would an individual stock.. Investors can also employ traditional stock trading techniques including stop orders or limit orders.
What is the Net Asset Value (NAV) of an ETF?
The Net Asset Value or NAV is the fund's assets minus its liabilities divided by the number of outstanding shares. NAVs are calculated at the end of each trading day. As a shareholder, if the NAV increases, it means the value of your holdings increases and vice versa.
What is the relationship between the NAV and the price of the ETF?
Each ETF has a NAV that is calculated with reference to the market value of the securities held by it. However, the trading price of an ETF like that of shares is determined by the supply and demand of the market. The trading price of an ETF may not be equal to its NAV, and this disparity may give rise to arbitrage opportunities.
An ETF is an open-ended investment fund that permits “in-kind” creation and redemption; arbitrageurs can take advantage of any discrepancies between the price of an ETF and the NAV of its underlying basket of stocks.
When the traded price of an ETF is higher than its NAV, an arbitrageur will sell the ETF units and buy the underlying portfolio of stocks (to create new ETF units to meet his sale delivery). And when the traded price of an ETF is lower than its NAV, the arbitrageur will sell the underlying portfolio of stocks and buy ETF units (to redeem for the underlying portfolio of stocks to meet his sale delivery). Such arbitrage activities help to ensure that the traded price of an ETF will usually be very close to its NAV.
How are ETF shares created or redeemed?
The creation of ETFs can be separated into three distinct flows or transactions:
- The Market Maker purchases a basket of shares (in the stock), as specified by the ETF custodian, for cash.
- This basket of securities is then exchanged with the ETF custodian for a set number of ETF units or shares (creation).
- The Market Maker then has an inventory of ETF shares through which to satisfy market demand for buy/sell orders.
Redemption is simply this process in reverse whereby a Market Maker will swap a defined number of ETF shares with the ETF custodian for the underlying basket of shares, which can then be sold for cash in the secondary market.
A Market Maker is a person or brokerage house that is always prepared to buy and sell securities in order to provide liquidity to the markets. By holding a disproportionately large number of a given security, a market maker is able to satisfy a high volume of market orders in a matter of seconds at competitive prices. If investors are selling, market makers are supposed to keep buying, and vice versa. They are supposed to take the opposite side of whatever trades are being conducted at any given point in time. In this sense, market makers, as the name suggests, are able to satisfy the market demand for a security and facilitate its circulation. Market maker profit through the market maker spread. They are supposed to buy or sell securities according to what kind of trades are being placed, not according to whether they think prices will go up or down.
What is a Key Investor Information Document (KIID)?
Each fund will have a Key Investor Information Document (KIID). This is a brief document which tells you about the key features and risks of the fund or ETF that you are investing into.