When you buy or sell a stock, you are basing your transaction on the predicted performance of one company. When you buy or sell an ETF, you are basing your transaction on the predicted performance of multiple companies.When you buy or sell an index, you are actually buying shares in individual companies. With an ETF, you are buying shares in a portfolio of those companies. So, if you had an opinion about a certain company in the index basket, you could make an adjustment by selling or buying shares of an individual equity (although, this is not common). With an ETF, you cannot adjust the individual equities in the portfolio.
ETF units are continuously created and redeemed based on investor demand. Investors may use ETFs for investment, trading or arbitrage. The price of the ETF tracks the value of the underlying index. This provides an opportunity to investors to compare the value of underlying index against the price of the ETF units prevailing on the stock exchange. If the value of the underlying index is higher than the price of the ETF, the investors may redeem the units to the asset management company that sponsors the ETF in exchange for the higher priced securities. Conversely, if the price of the underlying securities is lower than the ETF, the investors may create ETF units by depositing the lower-priced securities. This arbitrage mechanism eliminates the problem associated with closed-end mutual funds viz. the premium or discount to the NAV.
ETFs are not MFs
You may get confused between ETFs and conventional mutual funds. However, they are different on several counts. The only similarity between ETFs and conventional mutual funds is that they both provide you an opportunity to invest in a variety of stocks/instruments through a single instrument.
When you invest in a mutual fund, you need to buy and sell units from the fund house. Since buying and selling of ETFs is done on the stock exchange, the transaction has to be routed through a broker. If ever you can buy or redeem units in an ETF through the fund house, it is normally done in a pre-defined lot size. Typically, the lot size tends to be substantial making it feasible only for institutional investors and high networth individuals.
Since ETFs are traded on the stock exchange, they can be bought and sold at any time during market hours like a stock. This is known as ‘real time pricing’. In contrast, mutual funds can be bought and redeemed only at the relevant NAV; the NAV is declared only once at the end of the day. As a result, you have the opportunity to make the most of intra-day volatility in case of ETFs. This may not hold much significance if you are a long-term investor.
Mutual funds are always available at end-of-day NAV, whereas ETFs do not necessarily trade at the NAV of their underlying portfolio. In fact, the market price of an ETF is determined by the demand and supply of its units, which in turn is driven by the value of its underlying portfolio. But in case of a close-ended ETF the price remains fixed. Therefore, the possibility of an ETF trading below (at a discount) or above (at a premium) its NAV does exist.
