Exchange-Traded Fund (ETF)
An exchange-traded fund (ETF) is a collection of investments such as equities or bonds.
ETFs will let you invest in a large number of securities at once, and they often have cheaper
fees than other types of funds. ETFs are also more easily traded. ETFs are a sort of
investment fund that combines the best features of two popular assets: They combine the
diversification benefits of mutual funds with the simplicity with which equities may be
exchanged.
There is no transfer of ownership because investors buy a share of the fund, which owns the
shares of the underlying companies. Unlike mutual funds, ETF share prices are determined
throughout the day. A mutual fund trades only once a day after the markets close.
ETFs can be structured to track anything from the price of a commodity to a large and diverse
collection of stocks. ETFs can even be designed to track specific investment strategies.
Various types of ETFs are available to investors for income generation, speculation, or
hedging risk in an investor’s portfolio. The first ETF in the U.S. was the SPDR S&P 500 ETF
(SPY), which tracks the S&P 500 Index.
However, ETFs, like any other financial product, is not a one-size-fits-all solution. Examine
them on their own merits, including management charges and commission fees, ease of
purchase and sale, fit into your existing portfolio, and investment quality.
Types of ETFs
There are several categories of ETFs, each serving distinct investment purposes and targeting
different asset classes or strategies. Below are the major types:
1. Equity ETFs: These ETFs invest in a basket of stocks and aim to mirror the
performance of a stock index like the S&P 500, NASDAQ-100, or MSCI World. They
are ideal for investors seeking broad exposure to equity markets with reduced risk
through diversification.
2. Bond ETFs: Bond ETFs invest in various types of fixed-income instruments, such as
government bonds, municipal bonds, or corporate debt. They offer investors a way to
earn interest income while enjoying the liquidity of stock-like trading. These are used
to provide regular income to investors. Distribution depends on the performance of
underlying bonds which may include government, corporate, and state and local
bonds, usually called municipal bonds. Unlike their underlying
instruments, bond ETFs do not have a maturity date.
3. Commodity ETFs: These ETFs invest in physical commodities like gold, silver, oil,
or agricultural products. They allow investors to gain exposure to commodity price
movements without needing to directly buy or store the physical commodities.
4. Sector and Industry ETFs: These ETFs comprise a basket of stocks that track a
single industry or sector like automotive or energy. The aim is to provide diversified
exposure to a single industry, one that includes high performers and new entrants with
growth potential. BlackRock's iShares U.S. Technology ETF (IYW), for example,
tracks the Russell 1000 Technology RIC 22.5/45 Capped Index.
5. Thematic ETFs: Thematic ETFs target long-term investment trends and social
themes, such as clean energy, artificial intelligence, ESG (Environmental, Social,
Governance), or blockchain technology. They appeal to investors looking to align
their portfolios with specific beliefs or megatrends.
6. International and Regional ETFs (Foreign market ETFs): These funds are
designed to monitor non-Indian markets such as Japan's Nikkei Index or Hong Kong's
Hang Seng Index.
These ETFs invest in markets outside the investor’s home country or in specific
geographic regions like Europe, Asia-Pacific, or emerging markets. They offer global
diversification and access to foreign economies.
7. Inverse ETFs: Inverse ETFs aim to deliver the opposite return of an index or asset.
For example, if the underlying index drops by 1%, an inverse ETF may rise by 1%.
These are mainly used for hedging or speculative purposes. An inverse ETF
uses derivatives to short a stock. Inverse ETFs are exchange-traded notes (ETNs) and
not true ETFs. An ETN is a bond that trades like a stock and is backed by an issuer
such as a bank.
8. Leveraged ETFs: Leveraged ETFs use financial derivatives and debt to amplify the
daily returns of an index, often by 2x or 3x. A leveraged ETF seeks to return some
multiples (e.g., 2× or 3×) on the return of the underlying investments. If the S&P 500
rises 1%, a 2× leveraged S&P 500 ETF will return 2% (and if the index falls by 1%,
the ETF would lose 2%). These products use debt and derivatives, such as options or
futures contracts, to leverage their returns. They are high-risk and intended for short-
term trading, not long-term investment.
9. Index ETFs: These are funds that are designed to track a specific index.
10. Passive ETFs: Passive ETFs aim to replicate the performance of a broader index—
either a diversified index such as the S&P 500 or a more targeted sector or trend.
11. Actively managed ETFs: Do not target an index; portfolio managers make decisions
about which securities to buy and sell. Actively managed ETFs have benefits over
passive ETFs but charge higher fees.
12. Currency ETFs: Track the performance of currency pairs. Currency ETFs can be
used to speculate on the exchange rates of currencies based on political and economic
developments in a country. Some use them to diversify a portfolio while importers
and exporters use them to hedge against volatility in currency markets.
13. Bitcoin ETFs: The spot Bitcoin ETF was approved by the SEC in 2024. These ETFs
expose investors to bitcoin's price moves in their regular brokerage accounts by
purchasing and holding bitcoin as the underlying asset. Bitcoin futures ETFs,
approved in 2021, use futures contracts traded on the Chicago Mercantile Exchange
and track the price movements of bitcoin futures contracts.
14. Ethereum ETFs: Spot ether ETFs provide a way to invest in ether, the currency
native to the Ethereum blockchain, without directly owning the cryptocurrency. In
May 2024, the SEC permitted Nasdaq, the Chicago Board Options Exchange, and the
NYSE to list ETFs holding ether. And in July 2024, the SEC officially approved nine
spot ether ETFs to begin trading on U.S. exchanges.
15. Style ETFs: These funds are designed to mirror a specific investment style or market
size focus, such as large-cap value or small-cap growth.
Advantages of ETFs
• Simple to trade - Unlike other mutual funds, which trade at the end of the day, you
could buy and sell at any time of day.
• Transparency - The majority of ETFs are required to report their holdings on a daily
basis.
• ETFs are more tax efficient than actively managed mutual funds because they
generate less capital gain distributions.
• Trading transactions - Since they are traded like stocks, investors can place order
types (e.g., limit orders or stop-loss orders) that mutual funds cannot.
Disadvantages of ETFs
• Trading costs: If you invest modest sums frequently, dealing directly with a fund
company in a no-load fund may be less expensive.
• Illiquidity: Some lightly traded ETFs have huge bid or ask spreads, which means
you'll be buying at the spread's high price and selling at the spread's low price.
• While ETFs often mirror their underlying index pretty closely, technical difficulties
might cause variances.
• Settlement dates: ETF sales will not be settled for two days after the transaction; this
implies that, as the seller, your money from an ETF sale is theoretically unavailable to
reinvest for two days.
How ETFs are different from Index and Mutual Fund?
Parameter ETF (Exchange Index Fund Mutual Fund
Traded Fund) (Active)
Definition Traded fund tracking an Mutual fund Fund actively
index or asset, listed on tracking an index managed to
stock exchanges passively outperform a
benchmark
Management Mostly passive (some Passive Active
Style active ETFs exist)
Trading Traded like a stock on Bought/sold through Bought/sold through
Mechanism the exchange throughout AMC once a day at AMC once a day at
the day NAV NAV
Pricing Real-time market price Priced once a day at Priced once a day at
(can vary from NAV) NAV NAV
Liquidity High (depends on Lower than ETFs; Moderate to high, but
trading volume); can only end-of-day no intraday trading
buy/sell anytime liquidity
Minimum 1 unit (plus brokerage Varies (as low as Varies (often ₹500–
Investment and demat requirement) ₹500 in India) ₹1000 in India)
Costs (Expense Very low (typically Low (slightly higher Higher (1%–2.5% for
Ratio) 0.1%–0.5%) than ETFs) active funds)
Brokerage/Demat Yes, you need a trading No, you can invest No, you can invest
Required and demat account directly through directly through AMC
AMC or apps or apps
Tax Efficiency High – due to in-kind Moderate – Lower – frequent
creation/redemption redemptions may trading within the
process trigger capital gains fund can cause tax
events
Transparency High – holdings Moderate – Moderate – disclosed
disclosed daily disclosed monthly or quarterly
periodically
Tracking Error Low – due to real-time Moderate – due to Not applicable (since
arbitrage mechanism operational it doesn’t track an
limitations index)
Suitability For cost-conscious, DIY For passive For investors seeking
investors with market investors preferring active
experience simplicity outperformance,
willing to pay fees
Mechanism of ETFs
The operation of an ETF revolves around a “creation and redemption” process, facilitated
by Authorized Participants (APs), and takes place in two segments: the primary market
and the secondary market. Let’s break this down step by step:
1. Role of Authorized Participants (APs)
Authorized Participants are typically large financial institutions—like banks or brokerage
firms—that have an agreement with the ETF provider (also called the fund manager or
sponsor). They are the only entities allowed to create or redeem ETF shares directly with the
ETF provider. Their role is essential in maintaining the balance between ETF share supply
and demand and ensuring price stability.
2. Creation Process (Primary Market)
When investor demand for an ETF increases, the market price may rise above its Net Asset
Value (NAV). In such a case, APs step in to create new ETF units, which helps bring the
market price back in line with the NAV.
The creation process works as follows:
• The AP buys a basket of the underlying securities that mirrors the ETF’s
composition (e.g., all 50 stocks in the Nifty 50 for a Nifty ETF).
• This basket is delivered to the ETF provider.
• In exchange, the ETF provider issues a block of new ETF units to the AP—this is
typically done in large blocks called “creation units”, often 50,000 or 100,000
shares.
• The AP can then sell these ETF shares in the secondary market to individual
investors.
This process increases the supply of ETF shares and helps bring the price down if it was
trading at a premium.
3. Redemption Process (Primary Market)
When ETF shares are trading at a discount to NAV (i.e., lower than the value of underlying
assets), APs can redeem ETF units, which again helps restore pricing accuracy.
The redemption process works in reverse:
• The AP purchases ETF shares from the market.
• These shares are delivered back to the ETF provider.
• In return, the AP receives the equivalent basket of underlying securities.
• The redeemed ETF shares are cancelled, reducing the supply.
This arbitrage opportunity encourages APs to act whenever a price discrepancy exists,
ensuring the ETF price stays close to the true value of its holdings.
4. Trading in the Secondary Market
While the creation and redemption happen in the primary market, retail and institutional
investors usually trade ETF units on the secondary market, which is the stock exchange.
• Investors can buy and sell ETF shares just like they would any stock.
• The ETF’s price fluctuates throughout the day based on market demand and supply,
just like a stock does.
• Liquidity in the secondary market depends on trading volume, but it is also supported
by the ability of APs to create/redeem ETF shares if needed.
This makes ETFs more liquid and flexible than traditional mutual funds, which are only
bought or sold at end-of-day NAV.
5. Price Stability Through Arbitrage
The interplay between the primary and secondary markets allows arbitrage trading by APs:
• If the ETF trades above NAV → APs create ETF shares and sell them → supply
increases → price falls toward NAV.
• If the ETF trades below NAV → APs redeem ETF shares and sell the underlying
assets → supply decreases → price rises toward NAV.
This arbitrage ensures that the ETF price tracks the NAV closely, making ETFs transparent
and efficient investment vehicles.
6. In-Kind Transactions
One of the unique features of ETF creation/redemption is that they are often done “in-kind”,
meaning the AP delivers or receives the actual securities (not cash). This helps ETFs avoid
triggering capital gains taxes during the process, making them more tax-efficient than
mutual funds that must buy or sell assets to handle inflows and outflows.
