How ETFs Work
ETF shares, unlike mutual fund shares, are traded on an exchange, thus investors buy and sell ETF shares in market transactions. ETF shares are bought and sold by other investors. In contrast, with a mutual fund, an investor purchases a share directly from the fund and subsequently "sells" or "redeems" those shares from the fund.
When an ETF becomes public for the first time, or when it wishes to issue more shares, it sells shares to one or more financial institutions known as "Authorized Participants." Authorized participants are often major brokerage firms. Only approved participants are allowed to buy and sell shares directly from the ETF, and they can only do so in huge aggregations or blocks known as "creation units" or a "creation basket." The size of the creation basket may be specified by each ETF.
An authorized participant purchases shares from an ETF by assembling and depositing a specified basket of assets and cash with the fund, in exchange for which it receives shares in the ETF. After receiving the ETF shares, the authorized participant is allowed to sell them in the secondary market to individual investors, institutions, or market makers in the ETF.
The process of redemption is the inverse of the process of creation. A substantial block of ETF shares is purchased on the open market by an approved participant and delivered to the fund. In exchange, the authorized participant receives a predetermined basket of individual stocks or cash equivalent. Most ETFs charge approved participants a fee for each of these "creation basket" transactions, although the amount is generally small.
Benefits
• Lower costs of fees charged
• Instant diversification
• Liquidity
• Tax Efficiency
• Sector investing
• The ability to purchase in small amounts
• The availability of a wide variety of alternative investments.
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