The first difference between an ETF and a mutual fund is that when you buy an ETF you buy it from someone else in the market, and not the ETF trust – however, when you buy a mutual fund you buy it directly from the fund house. In this respect an ETF is like a share that trades on the stock exchange.
The following picture should make this clear.
When you buy a Reliance share from the stock market – Reliance Industries doesn’t get the money, and much in the same way when you buy an ETF from the share market – the ETF trust doesn’t get the money.
These units are being bought and sold between people in the secondary market and that’s different from mutual fund units. When you buy a mutual fundÂ – the fund gets your money, and issues you units based on the NAV on that day.
Now, the question is if you are buying and selling the ETF units from other small investors like you then where are the units coming from in the first place?
These units are being sold to you by what’s known as Authorized Participants who are large dealers / brokers / jewelers or other institutional players.
The Authorized Participants have the ability to buy and sell units directly from the ETF sponsor, and this process is called “Creation” and “Redemption”, and the units that are created like this are called “Creation Units”.
These creation units are very large in size, for example for a gold ETF liked Goldbees – the creation unit is one kilogram of gold, so the Authorized Participants needs to deposit one kilogram of gold with the ETF sponsor, and then the ETF sponsor creates new shares of their ETF and issues them to the Authorized Participant.
The Authorized Participant can then take those shares and sell a thousand of them in the stock exchange to thousand different small investors and thereafter these thousand investors can trade these units among themselves on the stock exchange.
Similarly, the Authorized Participant can take their ETF shares and redeem them with the ETF sponsor in exchange for cash.
This process is shown in the picture below.
To create new ETF shares, the authorized participant needs to deposit stocks or gold to the ETF trust and in exchange the ETF trust creates new shares and issues it to them. They in turn sell these shares on the stock exchange to the general public.
In that context, it’s important to keep in mind that when you go to buy a gold ETF or Nifty in the stock market – that has no effect on the gold holding or Nifty stock holding of the ETF trust. That’s only affected by the issue and redemption process of authorized participants.
This process also helps keep the NAV close to the traded value of the ETF because the authorized participants can arbitrage and make money whenever there is a difference between the two.
This is the fundamental difference between the structure of ETFs and mutual funds, and if you figure this out then the rest of the stuff is fairly easy. Here is a table that highlights some of the other differences / similarities between the two.
|Traded on a stock exchange||MFs are not traded on stock exchanges and you have to buy them directly from the fund house.||ETFs are traded on stock exchanges and you can buy and sell them on the exchange.|
|NAV or Quoted Price||MFs can only be bought and sold at their NAV||ETFs have NAVs and all ETFs show their real time NAVs on their websites. However, since they are listed, you can buy them on the quoted price.|
|Trading account needed||You donâ€™t need a share trading account to buy a mutual fund.||Since ETFs trade on the market, you need a trading account to transact in them.|
|Expense Ratio||Expense ratios on mutual funds are generally higher, especially because a lot of them are actively managed.||Expense ratios of ETFs tend to be lower since they are passive in nature.|
|Brokerage||Since you buy mutual funds directly from the fund house you don’t have to pay any brokerage on it.||You will have to pay the brokerage on ETF transactions since|
At the end of the day, both ETFs and mutual funds are investment vehicles that let you take a position on an asset class without exposing yourself to too much of one company’s shares or bonds.Â There are differences but the goals of both the products are the same.
This post is from the Suggest a Topic page.Â