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Understanding the ABC of Exchange traded fund

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5 (100%) 1 vote

Exchange Traded Fund

Exchange traded fund is a security that is marketable like any other financial security. It tracks the commodity, bonds and assets like any other index funds. ETF’s generally have higher liquidity and lower fees, thus making them an attractive class of investment for individual investors.

Looking at the details of the ETF, it’s a fund which owns the underlying assets such as metal, bonds, commodities, foreign Currency etc, then ownership of such assets are divided in the form of shares, similar to common shares of a company. Only difference is common shares gives the ownership right of a public Ltd. firm, where as ETF gives right of ownership of the underlying assets , which the ETF own, and it could be anything raging from bonds to commodities to currency as well. Holders of the ETF don’t have any direct ownership, but indirect ownership of the underlying asset.

Conception of ETF

ETF doesn’t involve direct cash investment from the investors. In the process of creation of ETF, a prospective ETF manager, is required to file the plan of ETF with exchange commission in place. Once the plan is approved by the commission, the Sponsor, i.e., the prospective ETF manager, comes in association with either a market specialist or an institutional investor who is empowered to create an ETF. It may be possible, ETF sponsor and authorized participants are the same. There is no as such necessity, that both have to be different individuals.  To understand the ETF working better, I will prefer a pictorial representation of the ETF, which will give clearer view of the working:

This is how a retail investor gets ETF into his account. For a retail investor it’s just like ordinary shares which trades in the market. An individual doesn’t need to be much bother about the working of the ETF. So now once he has his share of ETF, we must understand the redemption process of the ETF.

ETF can be redeem very easily, one way being clearly selling the ETF shares in the open market, just like we sell the common shares in the secondary market.

But the question arises, why will someone prefer to invest in ETF, rather than directly investing into the underlying asset? The foremost advantage of ETF is that, it is open for all class of investor, be it long term, short term, retail investor or institutional investor. For a long investor, it works as a way of diversification, and insulate them from daily trading activity, due to the ETF’s functional advantage. However, it even further provides liquidity in the market, thus aiding short term investor, who trades on the intraday basis. As initial investment is low, retail investors find it simple and convenient to buy or sell.

ETF even provide convenience of the intraday, purchase and sale on the exchange, thus getting a full taste of the price movements of the ETF in the market. Unlike mutual fund or other funds which sometimes trade at the discount to NAV, ETF is created in a way, which makes EFT trade close to its NAV, with certainty. This is possible, as authorised participants or large institutions are allowed to create or redeem outstanding units directly with the fund. As ETF‘s are listed on the exchange, thus it increases the reach and lowers the cost of operating the ETF.As the structure helps in reducing the cost of  collection, disbursement and other processing charges.

ETF is all time favourite for long term investor, as it is insulated from the in and out of the short term investors, as it doesn’t include extra cost for frequent subscription and redemption. Further making ETF dearer for the investor is that ETF generally tracks the movement of the underlying asset and there is no much divergence, this is generally due to lower transaction expenses and unique in kind redemption and creation process.

With much of advantages and easy investment procedure, ETF is one investment asset, which any individual can think of investing in.

The first Indian ETF launched was in January 2002 was “NIFTY BEES” (Nifty Benchmark Exchange Traded Scheme). It was index ETF, as the underlying asset in this was Nifty50.







MBA in Finance. Currently, working at Advisory Mandi as a Financial Advisor. Advisory Mandi is India's Best Stock Market Advisory Firm.

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