One of the main things that distinguish smart investors from those with poor strategy is the diversified investment. At a particular point in the market, every investor needs to look beyond their basic portfolios. Doing this is however challenging for many. Not only are great insights needed to make proper moves, but a thorough analysis of available options is mandatory. For investors in the financial markets, there are only too many options to venture in. What should you do as a retail investor who wants to diversify the portfolio? What options are there in the market? We will look at ETFs and why they are a great option to diversify.
Understanding the Basics
The first thing you will need to know is – what are ETFs? ETF is an acronym for ‘Exchange Traded Fund.’ This fund has ownership over third-party assets which are traded on a stock market. Such assets include bonds and stocks. The main difference between ETFs and other assets is the scope of ownership. ETFs typically represent a group of assets and not merely a single business. The value of the fund is thus representative of the asset performance in the markets. ETF investors get paid through dividends accrued due to ownership. Investors can also trade ETFs and make money.
To contextualize how ETFs operate, take the example of a company that launches an ETF focused on health stocks. This company can choose to release the funds it owns and trade them in the stock market. Additionally, the same company launches another ETF in the technology industry. If an investor purchases shares of this fund, then they can benefit from the profits accrued by the assets owned. Those profits would be collected as dividends in the form of direct returns.
Creation and Redemption
In the market of ETFs, creation, and redemption refers to the process where a company introduces new shares in the market and removes shares of an existing fund. During such a process, particular investors who have significant shares in the company are consulted. These investors are known as Authorized Participants (AP).
APs receive new shares from the firm incrementally over time but this process does not necessarily take place because of the creation of a new fund. It is possible to give shares to an AP so long as the value of the assets matches the exchange value.
Creation is a crucial part of correcting overvalued shares in an existing ETF. APs who purchase overvalued shares play a role in bringing prices in the market to acceptable levels. The process of redemption also works in a similar manner where the AP buys ETF shares and the firm gives them an amount of equal value. Redemption is also used to manage ETF prices.
To illustrate how creation and redemption works, take the example of a company X, which creates a $5 million ETF based on forex assets. This company wants to exchange the assets with an ETF firm. The chosen ETF firm thus creates an ETF and exchanges them at the same value with the assets owned by company X.
By doing this, the ETF company has managed to create neutrality in the market and company X has managed to get shares. The ETF firm thus can do anything it wants with the acquired assets. If the ETF firm trades these assets in the market with positive results, company X could decide to trade more assets with the firm and this would affect the future share prices. Due to the process of demand and supply, the share prices could either go up or down depending on the market performance each time company X trades with the ETF firm.
Why Invest in an ETF?
As stated earlier, an ETF offers a great opportunity to diversify. But why should you go for an ETF specifically? To start with, the stability in the market is a key benefit. Since the price of an ETF is based on multiple underlying assets, it is more stable and unlikely to be dragged down by a single asset. In addition, the ETF market is quite liquid. There are very low minimum purchase requirements and the market is always open for trading. The asset diversity that comes with ETFs is also great for investors. Most commodities that can be traded are usually available in the ETF market. Just like other markets though, it is up to the investor to determine which investment options are the best for their strategy.