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ETF or Exchange Traded Fund is a market security that tracks an index, commodity, bonds or basket of assets. Many think that it is like mutual funds but an ETF, unlike mutual funds, trades like a stock on a stock exchange. As ETF is an instrument for tracking security, it experiences price changes throughout a trading day. The constant purchase and sale of the ETFs in a day gives them a higher liquidity and lower fees in comparison to mutual funds. These benefits attract a lot of individual investors, especially those who are looking for a mutual fund alternative.

An Exchange Traded Fund is a type of fund that divides the ownership of the underlying asset which it owns into shares. The actual vehicle structure of investment will vary from country to country. Often there can be multiple structures co-existing in one country. The shareholders do not own or have a claim over the underlying investment directly. Thus, they have indirect ownership of these assets. The profits earned by the holders are proportionate such as interest earned or dividend paid. They might be entitled to receive residual value in case the fund liquidates. Just like shares, the ownership of these funds can be easily bought, sold or transferred. This is because ETFs trade in stock exchange like shares. (Information credit: https://www.easymarkets.com/eu/)

Creation and Redemption of ETF

The mechanism through which the supply of ETFs is regulated is known as ‘creation and redemption’. The authorised participants or AP of the market are typically the large institutional organisations such as market makers or specialists. They undertake the responsibility of obtaining the underlying assets of an ETF, and thus, are facilitators of both creation and redemption process of an ETF. AP being large specialised investors has high degree of buying capacity and only they can redeem the units of an ETF. Authorised participants assemble the portfolios (underlying assets) required and then turn them into funds that are exchanged for newly created ETF shares. If the AP wants to redeem the ETF, the ETF shares are returned to receive the basket consisting underlying share.

Trading ETF

There are two ways in which traders can trade in the ETF market. They are mentioned below:

Arbitrage

Traders can take advantage of momentary arbitrage i.e. buying and selling simultaneously. As both ETF and basket of underlying assets are tradable, it keeps the ETF price close to its fair value. Traders can earn from the differential, if they buy ETF for effectively less than the underlying securities and then sell the underlying assets.

Leverage ETF

The leverage ETF helps in tracking the opposite return of the underlying assets. Leverage ETF is also known as Inverse ETF that is created through the use of derivative products. For example, an inverse ETF would gain 1% for the 1% drop in the price of actual asset.

Traders get diversification in their index funds by owning an ETF. They also gain the ability to purchase as little as one share, buy one margin and sell short. There are a wide range of advantages that a trader will get if they trade in the ETF market with right amount of knowledge and skill.