There are two keys to understanding how ETF’s work:
Understand how Exchange Traded Funds differ from shares (refer to How are ETFs different from Managed Funds and Shares article) and secondly
Understand the unique creation/redemption process that is the signature of ETFs.
The redemption process is the means by which new ETF units are created or redeemed allowing the fund to shrink or grow, it is a little technical but well worth taking a few minutes to understand if you are serious about investing in ETFs.
ETF Creation/Redemption Process
An ETF unit represents an ownership interest in a pooled investment portfolio which is generally comprised of a basket of securities that have been selected because they track a particular index (such as Australian equities, small cap stocks, emerging markets or international markets).
ETF’s units can be bought and sold on the major stock exchanges, like shares, during trading hours at a price set via the creation/redemption process. The secondary market is the market you and I are used to dealing in and involves buying and selling ETF shares on the stock exchange, probably not much more explanation needed here.
The primary market however is more of a mystery and involves big institutions rather than retail investors and this is how the primary market allows investors to buy and sell ETF’s easily:
The ETF creation process (in other words the ETF needs to get larger because more investors want to buy units in it) works as follows:
Step 1: Authorised Particpants (AP’s) – the funds wants to get bigger so that means more people want to invest and give the fund their money to manage. Accordingly the underlying investment portfolio needs to get larger so registered stockbrokers (authorised participants or the middle men) buy/assemble the underlying shares that the ETF issuer is going to want (click here for an interesting article by Forbes on the middlemen).
Step 2: Once the AP has bundled up the underlying shares the ETF wants/needs into a minimum parcel size they then deliver these securities to the fund in bulk and in return the fund gives them ETF units.
Step 3: They can then sell these ETF units individually to you and me – in other words think of the AP’s as middlemen or wholesalers if it makes it easier.
The redemption process (in other words the ETF needs to get smaller because investors want to sell units) works as follows:
Step 1: The AP’s buy large number of units from you and me and collect them into one big bulk lot.
Step 2: They then give the units back to the ETF, who cancels them, and in return receive the underlying securities.
Step 3: They can then sell the underlying securities
Seems like a clumsy process but actually it is completely automated and the AP’s can create or redeem units with a few keystrokes.
How does the creation/redemption process keep the value of the ETF shares in line with the net asset value of the underlying securities?
Let us say the ETF shares are trading at more than the ETF’s portfolio’s estimated underlying value (intraday value).
In this case the AP can quickly make a profit (arbitrage) because there is someone (hopefully not you if you have read all the articles on this website!) who is prepared to pay more for the ETF shares than its underlying securities are worth! Fool!
So the AP would quickly buy the underlying portfolio shares, sell these to the ETF, get ETF units and then quickly flog those ETF units to which ever mug wants to pay more for them than it paid for the underlying shares and it makes a profit. A bit oversimplified and of course all happens super quickly but this is how the market price of an ETF is kept in line with the value of the underlying shares.
Neat Eh! The process can also happen in reverse.
In practice the arbitrage opportunities are quite small and the ‘spreads’ on ETF units are usually quite tight if the underlying securities are liquid and everything is working as it should, but you get the idea. And investors are happy to pay a small spread to the APs for providing this service.
If you read all this you now understand more about ETF’s work than 99% of ETF investors. Well done, knowledge is power!