Exchange traded funds

What is an ETF?

An Exchange-Traded Fund (ETF) is a type of investment fund that is traded on stock exchanges, much like individual stocks. It combines the benefits of mutual funds and stock trading in a unique way. While similar to mutual funds in that it holds a diverse range of assets—such as stocks, bonds, commodities, or currencies—an ETF stands out because it trades throughout the day on the stock exchange, with prices fluctuating like individual stocks.

These assets are managed to replicate the performance of a specific index or investment strategy. For instance, an ETF tracking the Sensex will hold the same stocks as the Sensex Index, allowing investors to gain exposure to the entire index through a single security.

ETFs are bought and sold on stock exchanges throughout the trading day, and their prices fluctuate just like individual stocks. This feature provides investors with liquidity and flexibility, allowing them to react to market conditions in real-time. With the combination of broad diversification, low costs, and the ability to trade like a stock, ETFs offer a versatile investment option suitable for a wide range of investors.

How do ETFs Work?

ETFs work by pooling various assets, such as stocks, bonds, currencies, or commodities, into a single fund. When you invest in ETFs in India, you buy shares of this fund, which gives you exposure to the underlying assets. This approach offers a way to diversify your investment portfolio.

For example, think of ETFs as a mixed fruit basket. Instead of buying apples, bananas, and oranges separately, you buy one basket that contains all of them. Similarly, an ETF pools together different assets into a single fund.

Here’s a breakdown of how ETFs operate:

1. Creation of the ETF:

• A fund provider or asset management company selects a set of underlying assets (like a specific stock index, sector, or commodity). It creates a fund that aims to replicate the performance of these assets.
• The provider pools these selected assets into a basket, creating a portfolio that the ETF will track.

2. Issuing ETF Shares:

• Once the portfolio is established, the fund provider issues shares of the ETF. Each share represents a proportional ownership of the fund’s underlying assets.

3. Trading on an Exchange:

• The ETF shares are then listed on a stock exchange, where they can be bought and sold by investors throughout the trading day, just like individual stocks.
• The price of ETF shares fluctuates during the trading day based on market demand and supply, though it generally stays close to the net asset value (NAV) of the underlying assets due to the creation/redemption process.

4. Ownership and Dividends:

• When investors buy shares of an ETF, they own a portion of the fund, not the underlying assets themselves.
• If the ETF’s underlying assets generate income (such as dividends from stocks or interest from bonds), this income is typically passed on to the ETF shareholders, either as cash pay-outs or reinvested in the fund.

5. Tracking Performance:

• Most ETFs are designed to track the performance of a specific index or sector. The fund's holdings are adjusted periodically to continue mirroring the index's performance as closely as possible.

6. Transparency and Management:

• ETFs usually disclose their holdings daily, allowing investors to see exactly what assets the ETF holds at any given time.