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ETF - Exchange Traded Fund

Additional Resources

  1. Are Exchange-traded Funds Dumbing Down The Markets? [gsb.stanford.edu]
  2. Lecture 4: Exchange-traded Funds [math.nyu.edu]
  3. Pricing Exchange Traded Funds [w4.stern.nyu.edu]
  4. Exchange Traded Fund (etf) [personalfinance.duke.edu]

ETF - Exchange Traded Fund

An Exchange Traded fund is a marketable security that tracks a commodity, bonds, an index or a basket of assets like an index fund. Unlike mutual funds, ETF trades like a common stock on a stock exchange. It experiences price change throughout the day as they are bought and sold. ETFs have higher daily liquidity and lower fees than mutual fund shares, this makes them an attractive alternative for individual investors. As trades like stock, an ETF does not have a net asset value calculated once at the end of every day just like a mutual fund.

Breaking down ETFs

ETF is a type of fund that owns underlying assets like shares of stock, bonds, gold bars, oil futures, foreign currency and so on. It divides the ownership of these assets into shares. The actual investment structure like corporation or investment trust varies from country to country and within one country there are multiple structures that co-exist. Shareholders do not directly own or have any direct claim to the underlying investments in the fund, rather they indirectly own assets.

ETF shareholders are entitled to proportion of the profits like earned interest or dividends paid. They may get residual value when the fund is liquidated. The ownership of the fund can be bought easily, transferred or sold like shares of stock. ETF shares are traded on public stock exchanges.

ETF redemption and creation

The ETF shares are regulated through a mechanism known as creation and redemption. The process is known as authorized participants. Authorised Participants are large financial institutions with high degree of buying power like market makers, banks or investment companies. Only authorised participants create units of an ETF. For redemptions, APS return ETF shares to the fund and receive the basket consisting of the underlying portfolio. The fund's underlying holdings are disclosed to the public every day.

ETFs and Traders

Arbitrage

Since ETF and the basket of underlying assets are tradable throughout the day traders can take advantage of momentary arbitrage opportunities. It keeps the ETF price close to its fair value. If the trader can buy ETF for effectively less than underlying securities then they can buy the ETF shares and sell the portfolios.

Leveraged ETFs

Some ETFs utilize leverage, gearing through the use of derivative products in order to create inverse or leveraged ETFs. Inverse ETF tracks the opposite return of underlying assets.

Advantages of ETFs

By owning an ETF, investors get the variation of an index fund and the ability to sell short, buy on margin and purchase little as one share. Another advantage is that the expense ratios for most ETFs are low when equatedwith an average mutual fund. While you buy and sell ETFs you have to pay the same commission to the broker that you would pay on any regular order.

There exists a potential for favourable taxation on cash flows generated by ETF. As capital gains from sales inside the fund don't pass through to shareholders they commonly are with mutual funds.