How Exchange Traded Funds or ETF Work

An exchange-traded fund (ETF) is an instrument that tracks a single asset, or a set of assets, and trades on the exchange like a stock. It is becoming a popular investment option, but you should know how it works before you put your money in it.

The process of creating ETFs starts with an authorized participant who is usually an institutional investor and acts as a middleman in trading in ETFs. The authorized participant prepares a basket of stocks or other assets to be kept at the custodial bank. Each basket can be about ten thousand to fifty thousand shares of the ETF. Once the custodial bank has verified the stocks, it gives the ETF shares to the authorized participant. These shares can then be sold in the market in the same manner as any other stock.

If the authorized participant wants to redeem the ETF, he will have to buy shares of that ETF from the market and get them exchanged with the individual stocks that are kept in custody with the bank. Thereafter, he can sell the individual stocks or return them to their real owners.

The fund manager, appointed by the bank, has to decide the procedure and the composition of the ETF. This role is usually played by large money management funds that can also find buyers for the ETF.

In the US, most ETFs are structured as open-ended investments, which provide a lot of flexibility in creation of a portfolio and which can participate in securities lending programs or use futures and options for achieving their investment objectives.

The plan of starting and operating an ETF has to be submitted to the SEC for approval. Depository Trust Clearing Corp, which records individual sale of stocks also records ETF sales in the same manner. This ensures protection of investors from any kind of mismanagement or cheating.

As far as the earnings for each party are concerned, the fund manager gets a fee, which is clearly mentioned, in the prospectus. The authorized participant mostly earns by trading in the difference in prices of the basket of stocks and the ETF. And the investor earns through appreciation in the value of underlying assets.

While the process of starting and running an ETF sounds complicated, as an investor you don’t have to worry about its safety. It ensures protection of buyers and is seen as a good investment option, with similar risks and returns as stocks, but with greater flexibility.

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