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For information on ETFs, how they work, types of ETF and their advantages and disadvantages read the following article.

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What is ETF

ETFs are Exchange traded funds. They track an index, a commodity or a mix of assets like the index fund. ETFs like stocks are traded during the day in the exchange. The return on investment depends on the rise in the index or the commodity value. In some sense the ETF is like a stock, as they are traded in the exchange on real-time basis. In another sense they work like Mutual funds as the underlying asset comprises of a set of stock (like the nifty or a commodity like gold).

Working of ETF:
The working of an ETF can be described as follows:

In ETF, we have what is known as the ‘authorized participants’. They are usually appointed by the AMC or the Asset Management Company. As the first step, all the shares that comprise the index (or the gold in case of Gold ETF) are deposited with the AMC. Once this is done the authorized participants receive the ‘creation units’ from the AMC. These units are called ‘in-kind’ units as against the ‘in-cash’ units of Mutual funds, since these are obtained against the underlying shares/gold. These units are a large block and therefore have to be split into smaller units. These smaller units are then bought or sold in the stock exchange by the authorized participants.
Theoretically speaking the trading in the market of the ETFs does not alter its corpus. Nevertheless, as the demand increases, the authorized participant can deposit more shares with the AMC and create fresh units to meet the demand. In case the redemption increases, they can give the units back to the AMCs take their shares back. Such shares are then sold in the market and the money is paid back to the investor.
Unlike the mutual funds in ETFs all trading happens in real time and therefore the effort and cost are minimal.

Mutual Fund, ETF- a comparative study:
The similarity between an ETF and mutual fund are not many as the working of the two varies largely. Both have underlying assets which make up their value and offer diversification in the investment. Again both are subject to market risks. But there ends any similarity between the mutual funds and ETFs.
On the other hand they are unlike each other in the following sense:
  • Conventional Mutual Funds can be made of any portfolio. ETFs are usually index-specific.
  • In the case of ETFs, the corpus does not change much as they are linked to the index.
  • In ETF, the AMC need not keep large cash reserves as the buying and selling of units between the investors takes care of the redemptions.
  • In ETF each investor pays for the additional cost unlike the mutual fund, where the cost is deducted from the NAV.
Advantages of ETF:
It is very convenient to trade as it is traded during the market trading hours.
Purchase of single unit is possible in ETF.
Since they are traded in real-time the effort and administrative costs are minimal.
Like the Index Fund they have high transparency.

  • In India, the concept is not quite popular, therefore the liquidity is low.
  • An additional brokerage should be paid, if you want to re-invest your dividends.
  • The ease of trade tends to increase the cost of the ETF.
  • SIP is not a very convenient option in ETFs.
Types of ETF:
Index ETF:
Most of the ETFs available today are index ETFs. This type of ETF tracks the performance of the index. This is done by including wither the contents of the index or having a sample of securities that make up the index. The two types of Index funds are “replication” and “representative” ETFs. Index ETFs that invest entirely in the securities underlying the index make up the replication ETF and those that invest most of the fund in representative samples and the remaining in other holdings (e.g. futures, options, etc).
Commodity ETFs or ETCs:
Commodity ETFs, as the name suggests, invest in commodities, such as gold, silver, other precious metals. Infact the first ever commodity ETFs were gold exchange traded funds. But commodity ETFs are index funds that track the non-security indices. Initially the commodities ETFs actually had the physical commodity itself. Now-a-days they have implemented the futures trading strategy.
Bond ETFs: Exchange traded funds that generally invest in bonds are called Bond ETFs. When the stock markets go through an economic recession, the bond EFTs is in demand. Unless brought and sold by a third party, the bond ETFs can give reasonable yields. 

Since ETF is an emerging investment option, many more new types are entering the market. Some of those are the Currency ETF, Actively managed ETF, Leveraged ETF, etc. How many of these survive the market realities is yet to be seen.