As you may know an Exchange Traded Fund (ETF) is a fund that trades like a stock. You purchase an ETF by way of a discount brokerage. To own 60 of the largest companies across all of the major sectors represented on the Toronto Stock Exchange you could simply enter the ticker XIU, and press Buy. And being a ‘stock’ it will trade throughout the day and it can change in price by the second.
A mutual fund may hold many of those same companies but it will get one price per day based on the NAV, the Net Asset Value. The mutual fund manager will calculate the value of all of the stocks within the fund, account for the percentage weighting within the fund and will then assign a price. For example the Tangerine Portfolios are index-based mutual funds, they get one price per day based on the value of all of the stocks and bonds within the portfolio. You can see those unit prices on this performance page.
When you buy or sell a mutual fund you don’t know what price you will get as that price is determined after market close. Those unit prices will also take into account all fees and trading costs and currency considerations.
An ETF trades throughout the day
When you purchase an ETF you will be able to see the current price as it trades throughout the day, and you’ll quickly know your price as soon as you make a buy or sell. It trades like a stock in the function of entering a ticker symbol for that buy or sell and that trade being executed on an exchange. But it is not priced in the same way that a stock such as Apple (APPL) will be priced.
With a publicly traded stock such as Apple the price is set by supply and demand. If I want to sell Apple for $200 per share and you want to buy those shares for $200, we have a deal. We exchange those shares and hence the word stock ‘exchange‘. But if there were no buyers at $200 I would have to lower my offer price. Perhaps there are buyers lined up $199. If I want to sell, I have to accept the $199. If there is great demand for a stock the stock price will increase. That is, if there are more buyers and sellers, the price will creep up incrementally. The buyers have to offer more to entice the sellers.
Why ETFs are not priced like individual stocks
Keep in mind that an ETF is a collection of securities, it’s a fund. It might hold hundreds or thousands of companies or bonds. Like a mutual fund an ETF is supposed to represent the total value of all of the holdings. If it traded based on simple supply and demand the ETF price would move based on the number of buyers and sellers not based on the value of the underlying assets. We need a third-party to enter the market to ensure that the ETF price always represents the true value of the underlying assets (that Net Asset Value).
Enter the Authorized Participants (AP). These are authorized and approved market participants who will create and destroy the ETF units to keep the price in line with the value of the assets.
Here’s a great overview from ETF.com
It is the AP’s job to acquire the securities that the ETF wants to hold. For instance, if an ETF is designed to track the S&P 500 Index, the AP will buy shares in all the S&P 500 constituents in the exact same weights as the index, then deliver those shares to the ETF provider. In exchange, the provider gives the AP a block of equally valued ETF shares, called a creation unit.
And here’s how the AP keeps the price in line the value of underlying assets.
Because an ETF trades like a stock, its price will fluctuate during the trading day, due to simple supply and demand. If many investors want to buy an ETF, for instance, the ETF’s share price might rise above the value of its underlying securities. When this happens, the AP can jump in to intervene. Recognizing the “overpriced” ETF, the AP might buy up the underlying shares that compose the ETF and then sell ETF shares on the open market. This should help drive the ETF’s share price back toward fair value, while the AP earns a basically risk-free arbitrage profit. Likewise, if the ETF starts trading at a discount to the securities it holds, the AP can snap up shares of that ETF on the cheap and redeem them for the underlying securities, which can be resold. By buying up the undervalued ETF shares, the AP drives the price of the ETF back toward fair value while once again making a nice profit.
And to keep the APs in check an ETF provider will have many APs keeping an eye on the funds. The more eyes on the fund, the closer the ETF will keep to its NAV. And while the APs make a profit off of this valuable and necessary service, they do eat all of the trading costs of creating and destroying ETF units. That is more much efficient compared to a mutual fund where the buying and selling of mutual fund units creates meaningful trading costs that are charged to all unit holders.
And who are this Authorized Participants? In Canada, it’s lead by the big banks – surprise surprise. BMO Capital Markets plays the leading role. National Bank is in there with RBC and TD. CIBC has a modest role and apparently Scotia is not in the game.
I’ll be back soon with the ‘safety’ of ETFs as an investment vehicle.
Contact me, Dale @ cutthecrapinvesting@gmail.com or better yet, leave a comment.
Interesting article I always wondered how they kept it near the NAV. Remember those flash crashes? People probably got stopped out there while a mutual fund would have seen no change. Seems like there is room for foul play. I look forward to the next article about the ‘safety’. I still think ETFs are great for individual investors though. I would have a much more difficult time buying corporate bonds or emerging markets without them.
Thanks Shawn. Great comment. Yes I remember that well. And that is part of the risk. A long term investor perhaps should not have stops, that’s setting us up for losses or compromised returns. Remember as well that the flash crash was a short term event and it was quickly corrected. I did write on that on Seeking Alpha. It was a larger technical trading event. The APs were not able to act. But they did as soon as they were able. I remember that crash in 2015? For the US market I skim 15 Dividend Achievers, I saw the Achievers ETF VIG drop some 20% or more while the stocks were only down 2% or so. I had the stocks all in my iPhone app. I could have made some quick money buying VIG. I knew what was happening but was scared to act. I could have done that arbitrage thing, ha. Yes I’ll be back on those risks and liquidity ‘risks’.
Well that filled a hole in my knowledge base – thank you for the clarification.
Thanks fbgcai, yes I invested in ETFs for a long time before I gave it much thought. I knew there was arbitrage but perhaps thought it was simply more sophisticated freelancers 🙂
Dale, thank you for explaining in more granularity how ETF’s survive. I’ve always wondered how ETF’s would be able to carry on with razor thin MER’s given inflated Wall St/ Bay St salaries or more specifically bonuses. The “risk free” arbitrage profit makes sense and I guess it funds the expenses along with the MER. Thank you so much.
Thanks Clever Rover, yes and in the end we often see very slight tracking errors (underperformance against the actual index) for large and liquid funds. It’s an efficient system. How index ETFs are created and priced and how they track in index over time is more than interesting. Who says indexing is boring? I will go sit in with an index creator soon, and I will report back.