The exchange-traded funds are a type of investment fund on exchanges.
They are invariably listed on stock exchanges and behave almost like stocks.
You can have an exchange-traded fund for any type of asset class.
Just like derivative, they derive the value from the underlying asset class.
You can choose stock, commodities or bond based ETFs as per your choice.
You can decide on the instrument based on your overall investment exposure.
This is also a popular arbitrage medium to take advantage of the price differential.
These are low cost, tax efficient and have limited risk exposure.
As a result, they are increasingly gaining popularity.
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What Are Exchange-Traded Funds?
Perhaps one of the simplest definitions of ETF is that it is an investment tool.
In many ways, you can draw a similarity with a mutual fund.
But the basic difference is the way in this instrument is traded.
Unlike Mutual Funds, there is no lock-in period in case of these ETFs.
They are pretty much traded like stocks.
You can exit and enter these ETFs at whatever time you would want.
The trading rate is also the market price.
So when you redeem Mutual Funds, you get the closing market rate of that day.
This is true, even if you redeem it at 1 pm or 3 pm in the afternoon.
But in case of ETFs, you will get the current rate.
So if you redeem an ETF at 1 pm, you get the trading rate at that point.
They mirror the rate of the underlying asset almost tick by tick.
So if you do not want direct exposure to stocks, this is a viable alternative option.
Shareholders have no direct claim or ownership of the stock.
However, despite the indirect ownership, they get part of the profit.
ETF shareholders earn a dividend on the stock that has dividend payout.
They can even get residual value if this fund gets liquidated eventually.
Overall ownership of the ETF is pretty simple.
You can buy or sell it the same way as a regular stock.
They are traded on exchanges just like a regular stock.
As a result, any kind of investor can buy these Exchange-traded funds.
This reduces the relative risk of their portfolio but at the same time helps them enjoy stock-like returns.
Transfer of exchange-traded funds to follow the same principle as that of stocks.
Who Created Exchange-Traded Funds
ETFs, as we see it now, were created about 20 years ago.
Though the original concept can be traced back to late 1700, there has been a gradual evolution.
The modern format was successfully launched in the 1990s.
Today there are more than $1 trillion assets under management in the ETF category.
In fact, these exchange-traded funds are so popular that many brokerages offer a special incentive for trading them.
The first successful exchange-traded fund was launched by the Toronto Stock Exchange in 1990.
The S&P 500 attempted its version after another three years in 1993.
It was called the SPDR and gained immense popularity.
Even today, it is an extremely popular and actively traded counter.
In fact, the launch of Index Mutual Funds in the 1970s played a crucial part in its conception.
For the first time, the concept of investing in an Index Fund took shape.
The end of the 1990s and beginning of 2000s saw a real pick-up in interest.
Vanguard came up with its first ETF in 2001, and by the end of 2011, there were 15 of them.
This is not just about sheer numbers, but it highlighted how popular this concept is.
The average investor was comfortable in investing in the Index.
They were ready to accept newer channels of investment.
This further egged large investors to device suitably attractive products.
Today ETFs are popular not just in US and Canada but the world over.
The range of underlying assets is also significantly huge.
From commodities to stocks to currencies and bonds, the list just goes on.
Average investor awareness in this regard is also increasing.
How Are Exchange-Traded Funds Issued & Redeemed?
The creation of Exchange-Traded funds is unique.
Unlike shares, there isn’t any public offer initially.
First of all, a group of investors gets together.
They are generally very large investors and are called authorized participants.
They have massive buying power and can often make or mar the market.
The authorized investors then bring together the basket of assets that will form the core foundation of the fund.
Now, this basket is handed over to the basic fund, and ETF shares are issued as per that.
Even when the redemption process happens, it follows the same principle.
The authorized participants return the ETF shares and get the basket of assets.
However, this is an extremely transparent medium.
The fund declares its value publicly every day.
However, this overall process is very different from how you can issue or redeem mutual funds.
Investors normally provide cash to create a fund and get cash back when they liquidate the fund.
You don’t need any fund to create Exchange-traded funds initially, at least.
Therefore, ETFs are always a bundle of stocks together.
A single unit of the exchange-traded fund can represent 10,000 to 500,000 shares.
This totally depends on the creator’s investment target.
But on an average, the ETF units comprise of roughly 50,000 shares.
This is a standard unit, but there is no hard and fast regulation in this regard.
The shares are sold public after APs, or authorized participants receive their shares.
On the public exchanges, the ETF shares follow the normal share trading regulations.
This then follows a relatively free market policy.
The public investors can then buy and sell these as normal shares.
The Advantages of Creation & Redemption Policy
The question is why do exchange-traded funds have such a different method of creation and redemption?
Why aren’t they issued or redeemed like mutual funds or bonds?
Well, the primary reason is this improves the efficiency of the ETF.
Moreover, it makes the entire share creation fair and transparent.
It works very efficiently in limiting commission and other transaction charges.
The authorized participants undertake most of the basic buying and selling in case of ETFs.
So they pay for the variety of trading charges and other fees.
They even cover the paper-work.
So unlike Mutual Funds, every small investor does not lose money in terms of transaction charges in every transaction.
That makes this payment procedure relatively fairer.
The bulk of expenses are borne by the lead investor.
Overall, therefore, these ETFs yield more return on every dollar spent.
This is also a crucial reason why these ETFs have become a popular trading alternative.
It protects the average investor from a wide range of these minor expenses at every step.
There is another important advantage of this creation and redemption process.
This process undeniably helps the ETF price to remain reasonable.
The price is as close to market value as possible.
This essentially refers to the market value of the underlying asset.
APs regulate the pricing through constant creation and redemption.
When the Exchange-traded funds are trading at a premium to the underlying asset’s value, APs might issue more shares.
They would buy the underlying asset and issue ETF share worth the value.
Once these shares start trading in the secondary market, a fair price is established.
The reverse happens when ETFs trade at a discount to underlying asset price.
The authorized investors buy the ETF shares and redeem them.
They exchange the underlying asset to book maximum profit.
Advantages of Exchange-Traded Funds
The advantages of Exchange-traded funds are one of the biggest triggers for the widespread popularity.
Suddenly investors found a relatively safe alternative to try out risky investment destinations.
Investor protection is the primary focus of the Exchange-Traded Funds.
But, that apart, there are many other positives.
The rate of return and cost of owning these are also quite reasonable.
They are by far amongst the cheapest products available and offer much higher returns.
The transparent dealings and the pricing mechanism is also a big positive.
It instills investor confidence in the product rather convincingly.
Simplicity Of Concept
Have you ever wondered why does the average investor only stick to select well-tested trading tools?
One of the basic reasons is lack of awareness.
But there is another key factor too.
The complexity of many of the modern investment tools overwhelms investors.
They are not sure about how and where to park the money.
The transaction charges are not spelled out clearly and many other similar issues.
The ETF, however, gained popularity because it is very simple to understand and execute.
For investors, it came across as a simple mathematical sum where 2+2 yielded 4 and nothing else.
Their structure is very simple to understand.
Getting started with ETFs is also simple.
Moreover, the ETFs help you yield power in the stock markets.
It is more like a launching pad for bigger gains.
Exchange-Traded Funds Are Cost Effective
Hidden costs are perhaps one of the biggest banes of equity market investment.
The Exchange-Traded funds, however, reduce that problem to a large extent.
The average commission is much lower in case of ETF.
Moreover, there is only one trade per transaction.
This further brings down the value of overhead costs.
There are no load fees in case of ETFs.
If you are bending double under the pressure of entry and exit load in mutual funds, this provides a welcome relief.
Compared to Mutual Funds, even the managing fees are much lower.
So on an average, an exchange-traded fund helps you in keeping the cost down.
This means you have more money to invest.
This also means your relative return would be much higher.
Exchange-Traded Funds Are Tax Efficient
If you compare ETFs with Mutual Funds, the capital gains tax is higher in Mfs.
This is because be it in MFs or straightforward Index trades, the tax is calculated on a daily basis.
However, in case of ETFs, there is no individual capital gains tax till the entire fund is sold off.
This makes the exchange-traded funds highly tax efficient.
The dividend payout in ETFs also provides a window for tax benefits.
On the whole, the average expenses come down to a large extent.
No individual transaction cost makes it relatively cheaper to most other trading tools.
This makes them very tax efficient.
Flexible Trading & Potential Derivative Options
It is, therefore, needless to mention that this is an extremely flexible trading option.
It is almost as simple as buying and trading stocks.
The prices of these ETFs are updated as frequently as share prices.
You do not have to wait for market closure to understand the exact worth.
Moreover, you can use equity market strategies for ETFs too.
You can short sell them, play on margin and at the same time stay put for a longer duration.
The investor can essentially play these counters as simply as stocks.
They do not have to undertake detailed studies to master it.
What’s even better, you even have ETF Options, swaps and Futures.
These contracts help to spread out the risk in your portfolio even better.
So an investor can also execute derivatives strategy on these exchange-traded funds.
Whether you want an Options Straddle or trade the ETF volatility, the choice is entirely yours.
The options are all available.
You can explore as many investment variants as you want.
You can even explore leveraged fund options based on your risk appetite.
Given the range of variants and trading possibilities, they are almost as extensive as stocks.
The relative return is also much higher as a result.
This is another key catalyst for its popularity.
The exchange-traded funds are relatively more transparent.
So the investor is never left guessing about the exact transaction and operational expenses.
They can easily assess the amount of investment and the kind of gain that they can expect.
The list of assets and the fund value is published daily.
Prices of the fund keep updating almost like the stock price.
This means the investor has a realistic idea of the overall fund performance.
They can also redeem anytime to take advantage of the best price.
Cut Down Multiple Transaction Hassle
Though ETFs often work like an Index, one big advantage is you can buy an ETF is one go.
You don’t need multiple transactions.
With the click of one buy button, you get an entire basket of assets.
This means you can set better investment targets.
You don’t have to chase independent stocks.
You don’t have to track the movement of every stock individually.
Also, you get a complete package, and you can base your investment targets as per that.
This reduces the hassle of investment to a large extent.
It also reduces the cost of transaction significantly.
You are only paying for one transaction.
Passive Exposure to Underlying Assets
This is perhaps one of the biggest advantages of investing in exchange-traded funds.
You enjoy the benefit of higher returns without direct exposure to risky assets.
These exchange-traded funds normally follow a particular index.
This means that they don’t need to be managed aggressively.
They seldom outperform the benchmark Index.
On the other hand, aggressive funds are meant to outperform their benchmark.
So it does not need aggressive fund management either.
This further lowers the management and transaction cost.
The investors, therefore, are more keen to explore this investment tool.
They can aspire to clock bigger gains without compromising their risk exposure targets.
Exchange-Traded Funds Are One of the Balanced Investment Tools
Overall exchange-traded funds are, therefore, one of the balanced investment tools.
They provide you with a healthy mix of risk and reward.
The indirect exposure also cuts down the relative risk associated with these investments.
Many investors use the ETF today.
The exchange-traded funds help them build healthy portfolios with limited risk propositions.
In many ways, they offer the safety of Mutual Funds without compromising the returns from direct stock exposure.
Whether you have a narrow investment profile or a well spread out one, you can add diversity through ETFs.
They can help you take advantage of even lesser know investment opportunities.
However, just like any other investment tool, you must read the offer document carefully.
It is never wise to invest just because someone advised.
You must assess the tax implications too.
Though it is a tax efficient tool, there is some amount capital gains tax.
You need to carefully assess all the aspects before investing in exchange-traded funds.