An exchange-traded fund (ETF) is an investment fund traded on stock exchanges on real-time basis, in a similar fashion as stocks of companies are traded. ETFs, hence, also emulate the nature of a stock market index in that they hold securities. Most ETFs track an index, such as the Standard & Poor’s (S&P) 500 , a commodity or other various assets similar to an index fund. Some of the unique features of exchange-traded products are that they come at affordable prices and are tax efficient. Because it trades like a stock, the net asset value (NAV) of an ETF is not calculated every day as in the case of a mutual fund.
The functioning of an ETF
In the case of normal funds, an investor buys and sells units directly from or to the fund manager. The money is first collected from the investors to form the corpus which is then used by the fund manager to build and manage the appropriate portfolio. Whenever an investor wants to redeem his units, a portion of the portfolio is sold and he gets paid for those units.
Role of institutional investors
The units in a conventional mutual fund are called ‘in-cash’ units. However, in case of ETFs, there are ‘authorized participants’ or institutional investors appointed by a fund manager.
Institutional investors are organizations such as banks and insurance firms which pool large sums of money and invest them in investment assets. They will first deposit all the shares that comprise the index with the fund manager and receive ‘creation units’ from him. Since these units are created by depositing underlying shares, they are called ‘in-kind’ units.
These creation units can be large blocks of tens of thousands of ETF shares, which are subsequently formed into smaller units and the authorized participants buy or sell them accordingly in the open market on the stock exchange.
In this way, every buy and sell technically need not change the corpus of an ETF unlike a conventional mutual fund. But if there is more demand, the authorized participants deposit more shares with the fund manager and get more creation units to satisfy the demand. Or if there is more redemption, then they give back these creation units to the AMC, take back their shares, sell them in the market and pay the investor.