Posted on March 9, 2009 - by Martin Lee

What Are ETFs?

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An ETF (exchange-traded fund) is a security that holds assets such as stocks, bonds, etc and is traded on a stock exchange.

Most ETFs are passively managed and track an index (such as S&P 500 or DJIA). The manager of the ETF will buy the stocks that make up the index and then issue out their ETF units (or shares) that represent ownership of the underlying stocks. These units are then traded on the stock exchange.

To ensure liquidity for retail investors, it is important for creators of ETFs to be market makers (or appoint one) to cater for the trading of these units.

Large institutional investors can create or redeem their units with the ETF manager directly. This creates arbitrage opportunities whenever there is a gap between the traded price of the ETF and its NAV. Therefore, most ETFs should trade at close to their NAV in normal circumstances.

For example, if the NAV of STI ETF is 1500 but it is only trading at 1400, someone can buy up the units on the market and then redeem them with the ETF manager for 1500.

Since there is very little fund management involved in passively managed ETFs, their annual fees can be as low as 0.1% p.a. As such, ETFs might be attractive to investors who would like to create a diversified portfolio that is more cost efficient than other collective investment schemes like unit trusts. Read more…

Related posts:

1. Be Careful of Leveraged and Inverse ETFs
2. 5 Myths About ETFs – Part 3
3. Concerns on ETFs