The idea of Exchange Traded Funds (ETFs) has been around since 1993; however it started to become more popular only a decade later.
Exchange Traded Fund (ETF) is a form of index fund trading like common stock on a stock exchange. Index funds in their turn are the subsets of mutual funds. Though they both have the same goal, Exchange Traded Fund (ETF) is commission-free while index fund is usually too expensive to trade.
In order to understand the complex mechanism of Exchange Traded Fund (ETF) we need to analyze the idea of mutual funds first.
The Difference between Mutual Funds and ETFs
Many investors cannot find enough time for investing in the stock market so they pool all of their money in order to hire a specialist who will manage the process of buying stocks instead of them.
In order to keep track of this crucial procedure, though, the investors receive ‘’shares’’ so that each of them knows exactly how much their total investment is worth. Thus the businessmen know how much money they need to spend in case of buying new shares and how much they can expect to earn when they sell them. This is how mutual funds work!
ETF is a mutual fund too in some sense but there is a crucial difference between these two terms in one aspect.
In case of ETF the investor has the privilege to purchase shares directly from a brokerage account. The investor is able to buy shares whenever and wherever he wants whereas in case of mutual funds the purchase can be made only once per day (usually after the close of trading).
Apart from that Exchange Traded Funds bring a huge amount of benefits like comfort, lower costs and incomparably better tax efficiency.
Mechanism Called ETF Creation/Redemption
ETF share supply is executed by a mechanism called creation and redemption. This procedure involves major specialized investors known in the investment world as authorized participants (APs).
Authorized participants are always large market makers such as banks, broker-dealers or investment companies.
These major financial institutions are responsible for creating or redeeming units of our subject of discussion Exchange Trade Fund. It should as well be mentioned that the process of creation and redemption of ETF shares involves no compensation for the APs.
Some ETF Disadvantages
Trading fees: The first obvious disadvantage of Exchange Traded Fund (ETF) is the need to pay trading fees. You will be required to pay a commission fee both for purchasing and selling a stock. ETF’s and mutual funds have quite different fee structures so you better measure ten times and cut once before choosing the best investment method for you.
Fluctuations: Although Exchange Traded Fund (ETF) offers diversification there is still the risk of volatility. Of course economic and social instability may also create obstacles to effective execution of this type of investment in a specific geographical area. It is vital to attach importance to the fund’s focus and the type of investment you make.
Liquidity: Another important factor in regard to ETF is definitely its liquidity. This term suggests that when you buy something you will never face lack of trade interest thus being able to get out of the investment very quickly. Note, that in case of thinly traded ETF’s you will have hard time doing so. The best way to make sure that ETF’s are liquid is to research the market movement in advance.