Initiated in 1993 in the U.S., an ETF combines stock exchange trading and funds into one product. They are in the form of securities certificates offering legal right of ownership over a basket of individual stock certificates.

In order to establish an ETF, involvement of a few different financial companies is necessary. These prices at which the ETFs are traded come close to their underlying assets. They are easily unwound and separated when no longer needed by the investors.

The fund manager creates the foundation for an ETF and is the central figure in its management. He or she must offer information in the form of a plan to show prospective investors how the ETF will function.

Companies such as the Vanguard Group and Barclays Global Investors direct pension funds combined with large stocks to global markets. As stocks are loaned off in this manner, ETFs are created. The same companies are able to affect a demand for newly introduced ETSs, through institutional or retail buyers.

An authorized participant or a ‘market maker’ initiates the creation of an ETF. Once the baskets of stocks are assembled, they are sent to special custodial banks for safekeeping. Here, the basket is double checked for accurate representation and the ETF shares are directed to the authorized participant. The fund manager monitors the basket of stocks deposited in the fund’s account at the custodial bank. Such accounts rarely see any activity, albeit a small cash inflow for dividends.

When the ETF is taken from the custodial bank by the authorized participant, it can be freely sold in the open market. Subsequently, ETF shares are sold and resold among investors.

When this process works in reverse, it’s known as redemption. Here, the authorized participant purchases a large bunch of ETFs on the open market and forwards it to the custodial bank. In exchange, he/she receives an equivalent basket of individual stocks which can be sold freely in the open market or returned to the relevant investors.

The fund manager receives a small cut of the fund’s annual assets as a fee and the investors who loan stocks to create a basket also get an interest fee for their services. The authorized participant earns through the difference in the price of the basket and the ETF.

The annual management cost of ETFs is low when compared to the other pooled investment carriers. ETFs also give direct access to the performance of key indices and sectors. Other benefits include low exposure to risks in comparison to single shares trading, absence of stamp duty (as duty is already paid when buying the underlying investments), flexibility in timing purchases and sales, and online availability.