What is an exchange traded fund and how is it different from other mutual funds and index funds? How will it be traded in the market?
From an investment point of view, ETFs are simply index funds that-unlike normal index funds-can be bought and sold at intra-day prices at a stock exchange throughout a trading day. In this respect they are more like shares rather than like mutual funds. Normal index funds are, of course, available only at end-of-day NAVs from fund distributors like any other fund. ETFs, since they need to be transacted upon throughout the day, are bought and sold through stockbrokers (using a demat account) just like shares.
Where an ETF really differs from an index fund is the manner in which it is created, bought and sold. In the case of normal mutual funds, investors pay cash to the fund, which in turn buys the stocks and bonds which constitute the fund. When ETFs are first set up the initial participants will give the fund the basket of stocks, which constitute the underlying index and take units of the fund in exchange. These market makers will in turn sell these units to investors just like a distributor does. The market maker is usually a broker. Since ETFs are sold through brokers, you will pay brokerage in place of loads. ETFs tend to have lower brokerage than normal funds have loads.
The NAV of an ETF is a fraction of the value of the index. Thus the NAV of an exchange-traded fund based on the Nifty can be one-tenth of the value of the Nifty. If the Nifty is at 3,000 points the NAV will be Rs 300. Effectively, this fractional pricing means that a basket of stocks like the Nifty can be purchased by an investor with a much lower outlay than it would otherwise be possible. This enables smaller initial investments than what most index funds offer, which is specially useful if you are just trying out index investing. By comparison, most nifty index funds would require a minimum investment of Rs 5,000.
In the case of other mutual fund schemes the fund buys back and sells units. In a way, an ETF resembles a close-end scheme, where the units are not sold back to the fund and investors buy and sell the fund units on the market.
Because they are traded on the stock exchange, ETFs have the potential to reach a much wider audience in the retail markets which is not economically viable for normal open-end funds. Also, the intermediary compensation model of ETFs eliminates conflict of interest between the investor and the advisor. In ETFs, the mutual fund do not pay anything to the intermediary but the investor pays directly like it happens when one purchases or sells shares.