How do ETFs work?
Exchange-Traded Funds (ETFs) are investment vehicles that combine features of mutual funds and stocks. They are designed to track the performance of a specific index, commodity, or asset class. Here’s how they work:
1. Structure
ETFs consist of a collection of underlying assets like stocks, bonds, or commodities. They are traded on stock exchanges, allowing investors to buy and sell shares throughout the trading day at market prices.
2. Creation and Redemption
Authorized Participants (APs) create or redeem ETF shares through a process called 'in-kind transactions'. When demand exceeds supply, APs buy the underlying assets and exchange them for new ETF shares. Conversely, when there’s excess supply, they can redeem shares, receiving the underlying assets in return.
3. Pricing
ETFs are generally priced based on the Net Asset Value (NAV) of the underlying assets. However, market forces can cause the share price to fluctuate above or below the NAV, especially during high volatility.
4. Benefits
ETFs offer diversification, low expense ratios, and tax efficiency. They also provide liquidity, as investors can react quickly to market changes by buying or selling shares anytime during market hours.
5. Considerations
While ETFs are advantageous, they also carry risks including market risk and tracking errors. Investors should perform due diligence before investing to ensure that an ETF aligns with their financial goals.