The ChoosaBroker Trading Academy

9.1. How ETFs Work

Exchange traded funds (ETF) have taken the investing world by storm. An ETF is a “basket” of numerous stocks and other investment assets that are combined to form a single investment product. They are created solely by large financial institutions, partly due to regulatory requirements, and partly because only large firms have the required assets to put together an ETF.

How are ETFs Created

A company creating an ETF has to first decide the assets that are to be included in the fund. Other details, such as fees and the number of shares that will be available to investors, also have to be settled. The next step involves seeking regulatory approval for the ETF. In the United States, the Securities and Exchange Commission (SEC) is the overseeing authority. Once approval is granted, authorized participants can begin to purchase shares of the ETF.

Technically, anyone can be an authorized participant. However, large investment firms are the major operators. ETFs don’t sell their shares individually. Instead, huge chunks of shares are pooled together to form “creation units.” A single creation unit may contain tens or even hundreds of thousands of shares of an ETF.

Creation units are actually never bought or sold. They are traded for equivalent amounts of assets, relative to the value of shares they represent. The ETF shares are placed with a custodian bank, where a fund manager is in charge, which gets a small percentage of the fund’s net profits.

The authorized participants now hold thousands of shares of the ETF and trade them on the open stock exchange. Retail investors can buy from these authorized participants.

Let us look at an example to better understand the above process. If an ETF is modelled to track the S&P 500, the authorized participant will buy shares of all the 500 companies that make up the index, and then deliver those to the ETF creator. In exchange, the ETF holding firm gives the authorized participant a creation unit.

Both parties gain from the above transaction – the ETF issuer gets hold of the stocks it needs to mimic the index, while the participant gets shares of the ETF, which he can resell to retail investors on the stock exchange.

The process works in reverse too. Authorized participants can purchase enough shares of the ETF to form a creation unit and then deliver those to the ETF issuer. In return, the participant receives the same value in underlying assets that constitute the fund. This essentially explains how ETFs work.

Importance of Authorized Participants

Since ETFs trade like stocks, their prices keep changing during the trading day, responding to market demand-supply scenario. If the ETF’s share price moves above the value of underlying securities, the fund gets “overpriced.” The authorized participant immediately jumps in to buy the underlying shares that make up the ETF, only to sell them in the open market. This helps drive the ETF’s price back towards its fair value.

Similarly, if the ETF trades at a discount to the assets it holds, the authorized participant snaps up shares of the ETF and redeems them for the underlying securities. By buying the undervalued ETF shares, the participant drives the ETF price back to its fair value.

This simple arbitrage operation helps to keep ETF prices in line with the value of its portfolio, and is one of the main advantages of investing in ETFs over the more traditional mutual funds.

Net Asset Value

Net asset value (NAV) is among the most vital data points for any investment fund. An ETF’s NAV is the sum of all its assets minus the liabilities, divided by the total number of outstanding shares. NAV provides a broad approximation of the fair value of a single share of an ETF, which in turn, helps investors create a reference point around which to form a market bias. For example, if you hold 10 shares of an ETF whose NAV is $10, and another investor offers $15, you have a solid case to sell those shares. In reality however, most ETF prices remain much closer to their NAVs.

Understanding Premiums and Discounts

Besides the NAV, which is calculated at the end of each trading day, ETFs also have a market price. Since like stocks, ETFs trade on an exchange, forces of demand and supply interact to create the market price. If the current market price of an ETF is above its NAV, the fund is said to be trading at a “premium.” Contrarily, if the ETF price is below the NAV, the ETF is said to be trading at a “discount.”

During relatively calm market conditions, an ETF’s market price and NAV are close. However, when markets become volatile, ETFs prices quickly change to reflect market sentiment, while NAV takes a longer time to adjust. This results in premiums and discounts.

Final Few Thoughts

The ease of use and low investment threshold makes ETFs an ideal choice for newcomers to financial markets. The key to successful investing is in keeping things simple. Adopt a strategy that fits with your investment objectives, maintain discipline and focus, and the returns will begin to flow. Please have a look at the best brokers for beginners for further assistance. If you are looking at day trading in forex for example, check our Best Forex brokerages.

Looking to trade? Choose from these excellent online brokers or these top-notch CFD brokers!