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ETF Liquidity Explained | ETF Creation & Redemption Process | Video 2 of ETF Education Series - YouTube
Channel: smallcase
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etf's have already taken the world by
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storm and are now also seeing increased
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adoption in India EDF industry has seen
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a 10x growth in the last five years but
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still many people have stayed away as
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they believe ETFs are illiquid so what
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determines ETF liquidity and are they
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really a liquid in this video we will
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tell all about ETF liquidity and its
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creation and redemption process if you
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want to know about the basics of ETF you
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can see our first video of this etf
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series so what do people mean when they
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see ETFs are illiquid as ETF is traded
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on the stock exchange and if there
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aren't enough people trailing ETF units
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it creates a bubble and investor has to
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pay more than the net asset value that
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is price of the unit in order to buy ETF
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units it's simple supply demand scenario
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in case of stocks there is a market risk
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when buying or selling large number of
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stocks because if stock doesn't have
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enough seller or buyer the investor has
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to wait till the liquidity comes in that
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stock in order to buy or sell it so you
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will be thinking that same is the case
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with ETF right not really
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PDFs are unique as liquidity in ETF can
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be easily created by authorized
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participants these are pre appointed by
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asset management companies to provide
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ETF liquidity on stock exchanges so
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authorized participants are basically
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middlemen in this scenario who helped in
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ETF creation and redemption process and
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helps in ETF liquidity now let's
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understand these with chocolates take a
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look at this chocolates display eat
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chocolate represents an individual
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company stock a chocolate packet
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represents in EDF a chocolate packet
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that is ETF contains specific selection
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of chocolates based on a predefined
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strategy for example an
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the price of chocolate packet that is
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ETF is based on the price of all the
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chocolates in it if the price of
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chocolates that is stocks increases the
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price of chocolate packet that is ETF
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increases and purchasing chocolate
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packets from the shop represents buying
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ETF from your broker to sum it up
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individual chocolate is a stock the
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chocolate packet is an ETF and the shop
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owner is your brokerage firm now let's
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understand how ETF creation and
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redemption process works
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to purchase a packet of chocolates
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investor goes to the shop and sees
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different packets of chocolates and
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orders the one he likes the shop owner
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who is the broker then goes to the
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chocolate market that is the stock
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market and fills the order the investor
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pays the shop owner receives the
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chocolate packet that is ETF and enjoys
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the chocolate that was simple right but
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what happens when an investor wants to
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buy a much larger order let's say the
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investor now wants 200 chocolate packets
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once again
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the shop owner goes to the chocolate
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market but there are not enough people
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who want to sell chocolate packets to
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fulfill 200 orders now what to solve
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this more chocolate packets can be
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created instantly for investor that is
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the ETF creation process due to increase
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demand of 200 packets and lack of
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liquidity the trading price of chocolate
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packets increases let's say it goes from
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rupees 300 to rupees 3 20 per packet the
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middleman that is warehouse manager now
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knows that more packets are required in
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the chocolate market the middleman then
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buys individual chocolates from the
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market required to make the chocolate
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packet that is ETF at rupees 300 as the
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individual chocolate prices are still
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the same the warehouse manager then
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sends these individual chocolates to
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packet manufacturers that is asset
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management companies to package the
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chocolates
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as per defined strategy once 200 packets
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are ready packet manufacturer that is
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asset management companies deliver them
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to the warehouse manager that is
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authorized participants and they then
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deliver it to the chocolate market and
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your broker then fulfills your 200 order
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in the process the authorized
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participants sell the individual
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chocolates to the asset management
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companies and rupees 300 and get the EPF
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unit of same value that is rupees 300
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and not the trading value thus making a
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profit on the spread the unique creation
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process of EDF means that even with
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large orders the cost of each packet
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remains approximately the same and the
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creation process does not require any
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additional time and effort in terms of
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investor all of this happens in the
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background and for you it's simple easy
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and convenient
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now if the investor wants to sell the
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200 packets the unique ETF redemption
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process comes in the picture as investor
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now want to sell 200 packets the supply
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increases and due to lack of liquidity
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the trading price of chocolate packets
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decreases as people always like to buy
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at a low cost let's say the price goes
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from rupees 300 to 280 but chocolate
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packet the warehouse manager now buys
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these packets at rupees 280 again the
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underlying individual chocolates are
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still worth rupees 300 the warehouse
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manager then sends these packets to
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packet designers that is asset
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management companies the designer
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separates the individual chocolates from
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chocolate packets and gives it back to
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warehouse manager the warehouse manager
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then sells individual chocolates to
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market at rupees 300 thus gaining a
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rupees 20 profit authorized participants
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buys or sells at the net asset value and
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not at the training value and they make
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money like that and helps in the
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liquidity of ETFs again like ETF
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creation II
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d/f redemption is an automatic process
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and for investors it is a
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straightforward process this unique
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creation redemption process is what
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enables ETFs to be low-cost and what has
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triggered their growth across the globe
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while this has been happening globally
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for a while now Indian investors have
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only recently shifted their focus on
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ETFs currently mutual funds are seeing
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tremendous inflows from Indian investors
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but ETFs are also catching up
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thanks to their simplicity and low costs
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in the next video in this etf series we
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will be covering etf versus mutual funds
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so subscribe to the channel and hit the
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