An Exchange-Traded Fund (ETF) is a type of investment fund that trades on stock exchanges, much like individual stocks. ETFs hold a diversified portfolio of assets (such as stocks, bonds, or commodities) and allow investors to buy shares that represent ownership in that portfolio.
Unlike mutual funds, ETFs trade throughout the day at market prices, providing flexibility, transparency, and often lower costs.
Why ETFs? Advantages of ETFs
ETFs have become popular because they combine many advantages:
Diversification: One ETF share can give exposure to hundreds or thousands of securities.
Liquidity: ETFs trade on exchanges throughout the trading day.
Transparency: Many ETFs publish their holdings daily.
Lower Costs: Often have lower expense ratios compared to mutual funds.
Tax Efficiency: In-kind creation/redemption helps minimize capital gains distributions.
Difference Between ETFs vs Mutual Funds vs SMAs
Feature
ETF
Mutual Fund
Separately Managed Account (SMA)
Trading
Intraday on exchange
Once per day after market close
Not traded on exchange; customized
Pricing
Market price + NAV
NAV at end of day
NAV based on holdings; periodic pricing
Transparency
Daily holdings (usually)
Monthly or quarterly holdings
Varies; typically less transparent
Cost
Generally low fees
Typically higher fees
Varies; often higher
Tax Efficiency
High (in-kind redemptions)
Lower (capital gains distributions)
Depends on manager
Minimum Investment
1 share
Varies; often higher
Usually high minimum
Key Players in the ETF ecosystem
ETF Issuer
The company that creates and manages the ETF.
Index Provider
Authorized Participants (APs)
Investors
Stock Exchange
Primary and Secondary Markets
The primary market refers to the creation and redemption process, where APs interact directly with the ETF issuer to either create new ETF shares or redeem existing ones in exchange for the underlying securities.
Creation: APs deliver a basket of underlying securities (or cash) to the ETF issuer. In return, the issuer gives the AP newly created ETF shares.
Redemption: APs return ETF shares to the issuer and receive the underlying securities back.
In the secondary market, investors buy and sell ETF shares on the stock exchange throughout the trading day at prevailing market prices, just like individual stocks.
Arbitrage Mechanism
APs exploit price differences between the ETF’s market price and its Net Asset Value (NAV).
This arbitrage keeps the ETF price close to the value of its underlying holdings.
Although ETFs generally trade close to their NAV, temporary mispricing can occur due to:
Market volatility or rapid price changes.
Illiquidity of underlying assets.
Time zone differences between the ETF trading hours and the underlying market hours.
Large buy/sell orders in the secondary market.
Suspended or halted underlying securities.
Arbitrage by APs quickly corrects these mispricings,ensuring ETF prices stay aligned with their intrinsic value.
The Role of Authorized Participants in ETFs
ETF issuers do not directly manage the inventory of underlying securities or transact with retail investors.
Instead, authorized participants (APs) play a central role by assembling, delivering, and redeeming baskets of securities to facilitate the ETF creation and redemption process.
This in-kind mechanism helps maintain tax efficiency and keeps ETF prices closely aligned with their net asset value (NAV).
APs also provide liquidity and engage in arbitrage, correcting price discrepancies and ensuring efficient market functioning within regulatory constraints.
The Role of Index Providers in ETFs
Index providers design and maintain indices: rules-based baskets of securities that represent a market or a segment of it. These indices serve as benchmarks or templates for many ETFs.
Key Responsibilities:
Define Index Methodology: Decide how to select, weight, and rebalance constituent securities.
Maintain the Index: Update index constituents and weights based on corporate actions, market changes, or methodology rules.
Publish Index Data: Provide real-time or end-of-day data used by ETF issuers and APs to price and manage ETFs.
Index One is a specialized index provider delivering innovative, transparent, and investable indices that power ETFs and other investment products.
We supply the index rules and constituent data essential to ETF issuers, including the underlying data used in ETF basket files (such as PCFs and tracker files). Index One offers dynamic and customized index solutions tailored to evolving market needs, supporting both active and passive strategies,
ETFs tracking Index One indices
Here are some ETFs tracking indices calculated by Index One.
An institutional entity (broker-dealer) authorized by the ETF issuer to create or redeem ETF shares directly with the issuer. APs facilitate liquidity and help keep ETF prices aligned with NAV
Net Asset Value (NAV)
The per-share value of the ETF’s underlying assets, calculated as the total value of holdings divided by the number of ETF shares outstanding. NAV is typically calculated at the end of each trading day.
Arbitrage
The process by which APs buy or sell ETF shares and underlying securities to profit from price discrepancies, ensuring ETF prices stay close to NAV.
Creation/Redemption
The process of issuing (creation) or redeeming ETF shares in exchange for the underlying basket of securities or cash. This happens in the primary market between APs and the ETF issuer.
In-Kind Transfer
A method where securities, rather than cash, are exchanged during creation or redemption, which helps minimize taxable events within the ETF.
A daily file published by the ETF issuer that lists the securities and quantities APs must deliver or receive to create or redeem ETF shares. This file guides APs in assembling the ETF basket.
Contact
contact@indexone.io
Kemp House 160 City Road London United Kingdom EC1V 2NX
