An exchange traded fund, or ETF, is a marketable security tracking bonds, commodities or other baskets of assets, such as an index fund. Unlike a mutual fund, ETFs trade just like the shares of an equity stock on stock exchanges. An Exchange Traded Funds will undergo price changes over time as they are traded on the market.

They will usually have a much higher daily liquidity and significantly lower fees than the shares of a mutual fund, which makes them attractive to retail investors. Since an ETF trades just like equity shares, it does not calculate its NAV, or net asset value, at the end of every trading day like mutual funds do.

Exchange Traded Funds are funds that own the underlying assets (shares of stock, oil futures, bonds, gold bars, currencies and so on), and divides the ownership of these assets into marketable shares. The investment vehicle structure used will vary by market, and multiple possible structures can co-exist in the same market.

The shareholders of an Exchange Traded Funds do not have direct ownership or any claim to the underlying assets of the fund. Instead they own these underlying assets indirectly through their ownership of the fund itself.

How They Work

An ETF shareholder is entitled to a portion of any profits, such dividends paid or interest earned, and they are often entitled to a residual value if the fund is liquidated. Ownership in the fund is easily bought, sold and transferred, since the shares in an ETF shares can be traded in public stock exchanges.

Exchange Traded Funds share supply is regulated through creation and redemption. The mechanism of creation and redemption involves a small number of specialized investors called “authorized participants”, or APs. APs are major financial institutions that have a lot of buying power. Only an AP can make or redeem the units in an ETF.

During creation, the APs assemble a portfolio of underlying assets, and then turn that basket over to the control of the fund in exchange for ETF shares. Similarly in the case of redemptions, the APs return the ETF’s shares to the fund and get back the basket of the underlying assets in the portfolio.