Introduction to ETF
An Exchange Traded Fund is an investment fund that is listed and traded on stock exchange. Let us understand what is the mechanism between an Exchange Traded Fund.
The creation of ETF occurs when the Participating Dealer buys securities from the market and gives them to the Fund Manager in exchange for units in the fund. These securities form the portfolio of the fund and are held by a custodian. These units are then listed on the stock exchange. After listing, the units are traded on secondary market just like stocks. The trading occurs between the investors and Participating Dealer in its duty as market maker to provide liquidity and keep market prices close to fund’s NAV.
When market demand of these units drives the market price above the NAV of the fund, the Participating Dealer generates a new supply of units through the creation process. Similarly, when market demand declines and units are trading below NAV, the Participating Dealer buys units from the market and returns them to the Fund Manager in exchange for securities.
Comparing ETFs with Unit Trusts
ETFs are investment funds (mainly index funds) listed and traded on stock exchange. Although both unit trusts and ETFs are similar in the way that they are managed by professional fund manager, there are some differences.
Investors typically buy and sell unit trusts through a distribution channel. It can be through banks, financial advisers or online portals. ETFs are bought and sold on the stock exchange through a securities broker.
When buying unit trusts, investors pay an upfront sales charge typically in the range of 3% to 5%. ETF investors pay brokerage fee of about 0.25% and clearance fees from the stock exchange.
NAV of unit trust is based on forward pricing and actual NAV is only known after placement of the order. Buying and selling is based on end-of-day prices. Investors do not know how many units they have purchased until the day after the pricing day. By contrast, ETF pricing is based on market quotation, made known to investor when the order is placed. There is greater pricing certainty with ETFs.
ETFs are traded throughout the day, investors in ETFs enjoy greater liquidity. Unit Trust investors can liquidate their holdings only following a pricing which occurs once a day.