The Basics of Investing in Exchange Traded Funds (ETFs)
What are Exchange Traded Funds?
Exchange traded funds (ETFs) are mutual funds whose shares trade on stock exchanges just likes any other stock. Investors can buy shares of ETFs just as they buy shares of any other company, through stock brokers.
Unique features
ETFs tend to trade at prices very close to their Net Asset Values (NAVs). This is facilitated by a unique mechanism involving arbitrage. Certain large players and institutional investors are designated as “Authorized participants” and are allowed to create and redeem shares of these ETFs by exchanging shares of the ETF with a basket of the shares that the ETF tracks.
For example, if ABC ETF tracks the Dow Jones Industrial Average and has an NAV of $9.31 but trades on the NYSE at $9.41, an authorized participant XYZ Investments Corp would simply buy the equivalent number of shares of the components of the Dow Jones Industrial Average and give this basket to the mutual fund that manages ABC ETF, which would then issue shares of ABC ETF to XYZ Corp. XYZ would immediately sell these ETF shares in the open market for $9.41 and make a profit of $0.1 per share. If XYZ sells 1 million shares, it would earn $100,000. This would bring down the price of ABC ETF in the open market.
The inverse transaction would occur if the ETF were to trade below its NAV.
Thus, arbitrage ensures that ETFs trade at prices that are very close to their NAVs.
Advantages
1) ETFs do not involve entry or exit load. Thus, they are efficient means of getting exposure to the underlying basket of securities.
2) Most ETFs track a given index. Thus, they provide good diversification benefits.
3) Since they usually trade at prices very close to their NAVs, ETFs are cost-efficient. Investors however, have to pay brokerage charges to buy/sell shares of ETFs.
Though it is possible that illiquid ETFs may trade at discounts/premiums to their NAV, it is very rare because of the above mentioned mechanism.