ETFs are funds or collective investment schemes where many investors pool their money together and invest collectively into assets.
An ETF, or Exchange Traded Fund is an investment fund that can be traded at an exchange from one private investor directly to another private investor without the need of an institution or 3rd party which determinates a price for the fund. The price is negotiated between buyers and sellers and by demand and supply of the market.
Exchange Traded Funds can track basically everything. For example they can track an index (such as DAX, FTSE 100, MSCI World or S&P 500), commodities (such as Gold, Iron, Oil, Corn, Cattle), countries, regions, bonds, real estate, even bitcoins or basically anything which has a value.
ETFs are similar to Mutual Funds, but the difference is, it can be traded on a Stock Exchange similar to a common stock. While Mutual Funds are mainly traded with the fund company (and the buy in price is given by the mutual fund company) the price of ETFs changes throughout the day, as they are bought or sold in the market.
ETFs allows investors to gain broad exposure of the entire stock market or anything with an ease, consistently at lower cost, than many other forms of investing.
What are ETFs ? Detailed Explanation
ETFs or Exchange Traded Funds are special kind of Mutual Funds which are structured, managed and regulated like Mutual Funds, but it can be traded on the Stock Exchange during market hours just like Stocks, based on supply and demand equation in the market.
Just imagine ETF as a basket and each basket holding marketable securities such as stocks, commodities, currencies, or bonds etc. Most ETFs are passively managed funds and therefore cheaper because no portfolio manager salary has to be paid. This is the reason why ETF Funds are becoming more popular investment vehicle.
There are over 6000 Exchange-Traded Funds on 60 exchanges around the world, worth of $3 Trillion of Assets.
How does an ETF work? ETFs Arbitrage Mechanism
Basically two scenarios have to be separated. One scenario is that an investor wants to buy or sell an ETF at a stock exchange (or called secondary market), for example at the SIX (the Swiss Stock Market in Zürich). The investor gives a limit order to the exchange to sell the ETF for 10 CHF, this order is visible to other market participants and if they want they can buy the ETF for 10 CHF. The ETF goes from one investors hand to the other investors hand and only a small commission for the broker and exchange has to be paid.
In the first scenario the investor trades (with the help of a broker) directly to another investor and the ETF is traded like any listed company, for example like a Nestle, Credit Suisse, Julius Baer, UBS or any other stock (see left side of the chart - ETF as a listed company).
The second scenario (right side of the chart) is that the ETF is "produced" or first listed at the stock exchange. In the first listing there is a group of institutional investors, here called as Authorized Participants or APs, through which investors buy or sell ETF shares.
For Physical ETF, AP buy all the underlying securities of an index to create securities basket and transfers it to ETF Issuer in exchange of ETF Units, AP then sell these ETF Units to the retail investors.
For Synthetic ETF, AP transfers cash to the ETF Issuer. ETF Fund then enters into the swap agreement with Counterparty to track the performance of an index. AP receives ETF Units in exchange of cash to sell it to retail investors.
This is how an ETF works, whereas the goal of an ETF is to replicate an index. There are two popular replication methods that ETF issuers used to replicate the performance of an index fund:
Physical Replication tracks its target index closely. It is transparent and easy to understand, since the investor knows the nature of his investment and can track the composition of the index on daily basis.
Whereas in Synthetic Replication, there is an involvement of Counterparty, such as Investment Bank. The ETF Fund and Counterparty enters into the swap agreement in which the Counterparty agrees to provide the returns of an index to ETF Fund in exchange for performance of the Collateral Basket.
Benefits of ETF:
ETF comes with a bunch of benefits, when compared with the different investment options. Here we will just take a look at some of the benefits of ETF.
- Intraday Trading
- Lower Fees
Difference Between ETFs and Mutual Funds
Let us understand this with an example:
When the investor invests in a mutual fund then the money goes to Mutual Fund Company and fund manager calculates the amount invested and value of existing assets, based on that fund manager allocates shares to the investor. The next morning, the manager interacts with you sends you shares, emails your perspective and then he goes to the market and buys securities with your money. Probably he or the sales person who has sold you the mutual fund will ask for a agio or a fee and only a percentage of your money goes into the investment while some money has to be paid for the sales team or bank.
Whereas ETF Funds works differently, to buy an ETF share, you simply place buy order with your broker. Now, here you do not buy shares directly from ETF Fund, there will be another investor who is ready to sell the shares to you, and once price is matched, shares get credited to your account. There is no interaction between you and ETF fund. There is no fund manager in between, which results in less work.
Less Work = Less Cost!
The design of ETF System automatically makes it cost-efficient.