HOW ETFs WORK
ETFs operate by combining the characteristics of mutual funds and stocks, making them a hybrid investment tool.
- Creation and Redemption:
ETFs are created and redeemed in large blocks of shares, known as “creation units.”
Authorized participants (APs), typically large financial institutions, create these units by delivering a basket of underlying assets to the ETF provider in exchange for ETF shares. Conversely, they can redeem ETF shares for the underlying assets.
- Trading on Exchanges:
Once created, ETF shares are listed on stock exchanges where they can be bought and sold throughout the trading day at market prices.
This intraday trading capability is a significant advantage over mutual funds, which are priced only at the end of the trading day.
- Net Asset Value (NAV):
The NAV of an ETF is the total value of its assets minus its liabilities, divided by the number of outstanding shares.
While the ETF’s market price can fluctuate during the trading day, it generally stays close to the NAV due to the arbitrage mechanism employed by APs.
- Dividends and Interest:
ETFs may distribute dividends or interest earned from their underlying assets to investors.