How do ETFs Work?
A fund provider, often known as an “authorized participant” (APs), creates a diversified portfolio of assets, such as stocks, debentures, bonds, currencies, or other securities. The assets are typically selected by the fund providers, who then form a fund to track and replicate the performance of different market indexes. Funds (ETFs) are then divided into shares, that are listed on the stock exchange and are sold to the investors. Let’s understand this in steps:
1. Creating ETFs: The “authorized participant” (APs) creates a portfolio of diversified assets and then tracks the performance of the index that ETFs aim to hit.
2. Listing and Trading: Once the ETFs are created, it is divided into shares that are listed on a stock exchange and are capable of being traded freely like any other stock. An investor just buys a share in ETFs and has no ownership right over the underlying assets in the Fund.
3. Pricing: ETFs have a manager who continuously quotes the bids and replicates the prices of ETFs along with ensuring that the prices of ETFs remain aligned with the Net Asset Value (NAV) of the underlying assets.
4. Tracking the performance: The Investing managers continuously evaluate the performance of the ETFs to represent the performance of the underlying sector or index it aims to track. ETFs are adjusted timely to image the changes in the index composition.
5. Charging Fee: Like Mutual Funds managers, ETF’s investment managers also charge a fee for their services as management fees, administrative fees, and other operational costs. However, such costs are lower than that charged by Mutual Funds managers.
6. Buying and selling: After investing and owning a share in ETFs, investors are free to buy and sell the shares on a stock exchange at prevailing market prices. Such prices are determined by the demand and supply in the market and are likely to be different from the NAV of the underlying assets in the fund.
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