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ETFs Part 3: Behind the Scenes with ETFs

Find out who creates ETF shares and how they’re traded.

Anytime you invest your money, it is important to have an understanding of what exactly it is you are buying. Before diving into this topic, it may be helpful to note that in a sense, ETFs have a lot in common with cars. When it comes to cars, different styles appeal to different people. The same is true of ETFs. Different investors have different goals and objectives, and will therefore naturally be drawn to different avenues of investment. Likewise, in the case of cars and ETFs, the reality is that it is not absolutely necessary to understand exactly what goes on “under the hood” in order to own one or to use one.

In other words, investors can enjoy the highs and lows associated with both cars and ETFs without completely understanding the complicated series of events that actually make them work. But in the interest of being as well informed as possible, let’s go ahead and take a look “under the hood” of the ETF share creation process.

Creating shares of ETFs

To better understand the unique nature of ETFs, let’s first look at how traditional mutual funds are traded. One of the more common types of mutual fund is referred to as an “open-end fund.” Open-end mutual funds trade at what is known as their “Net Asset Value” (or NAV). This is the total dollar value of all of the securities held by the fund, divided by the total number of shares outstanding. For an open-end fund, the NAV per share is calculated after the close of trading each day, and any fund shares that are to be sold that day trade at that price.

Shares of open-end funds are typically either bought from or sold directly through the fund company itself or via a mutual fund marketplace offered by a brokerage firm. These marketplaces offer customers the ability to buy or sell a wide variety of mutual funds directly from a standard cash or margin account.

Ultimately, when an investor buys shares of a typical mutual fund, the fund company adds the money used to buy the shares to the assets of the mutual fund. In turn, the fund company issues fund “shares” to the buyer. As investors choose to sell shares—again, either directly with the fund company or via a mutual fund marketplace—the fund company redeems the investor’s shares and gives them cash in return.

The creation of an ETF share involves a very different process, as they are essentially created by large investors. These investors are technically referred to as “Authorized Participants,” or APs. Typically an AP is a market maker, a specialist, or some other large financial institution with a great deal of buying power, and the ability to enter and exit large positions quickly. Let’s break down the process into five steps for the most basic transaction:

  1. The AP first acquires the securities that the ETF is designed to hold. For instance, if an ETF is designed to track the S&P 500 Index, the AP will buy shares in all the stocks that comprise the S&P 500 Index in the same weights as the index itself.
  2. Next the AP delivers those shares of the individual stocks to the ETF provider.
  3. In exchange, the ETF sponsor forms a block of ETF shares, formally known as a “Creation Unit.”
  4. The ETF sponsor then issues these newly created ETF shares to the AP. These units are usually formed in 50,000-share blocks.
  5. The AP can then hold those shares or is free to sell them in the marketplace.

Of course, an AP can also reverse the process and redeem ETF shares with the ETF sponsor and receive, in return, the underlying securities.

This unique “creation/redemption” process is important for ETFs in a number of ways. For one thing, it’s what keeps ETF share prices trading closer to the fund’s underlying net asset value, or NAV. Because an ETF trades like a stock, the price of the ETF shares will fluctuate during the trading day, based on supply and demand in the marketplace. As a result, it is possible for the ETF share price to rise above or fall below its NAV. However, if the ETF share price gets too far above or below the NAV, APs will swing into action to force the ETF share price back to its net asset value.

If the ETF share price becomes more expensive than the sum of its underlying securities, an AP can:

  1. Buy up the underlying securities.
  2. Form a creation unit and exchange it for ETF shares.
  3. Sell the ETF shares on the market.

In the process, the AP can pocket the difference between the share price for the ETF and the net asset value of the underlying shares. Conversely, if the ETF share price falls below the sum value of the underlying securities, then the AP can:

  1. Purchase a creation unit's worth of ETF shares.
  2. Redeem them for their underlying securities.
  3. Sell the underlying shares in the market, once again pocketing the difference between the share price of the ETF and the net asset value of the underlying securities.

Remember that the large traders who will buy and sell ETF creation units can buy or sell baskets of stocks almost instantaneously via today’s electronic markets. Thus, if they see an opportunity to buy or sell stock shares and ETF shares for a small but quick profit, they will take advantage of that opportunity.

This ongoing buying and selling pressure creates the dynamic that constantly nudges an ETF’s price to remain near its net asset value. It is this process that serves to keep an ETF’s price in line with the actual value of it’s underlying portfolio.

So as we’ve seen, there is a lot that goes on behind the scenes in creating ETF shares, and keeping the price of those shares in line with the actual value of the underlying securities. Fortunately, this process goes on without any action required on the part of investors.

It should be noted that the process is not perfect. In the instance of an unexpected event (example, a “flash crash”) price and bid/ask spreads can be temporarily affected. Still, these instances are rare and arbitrage buying and/or selling will still be working to correct any imbalances as quickly as possible. Still, understanding how this process works can give you comfort and confidence so you can best decide if ETFs are right for your portfolio.

Though we’ve covered how ETFs are created, move on to the next article in this series to learn what you own when you purchase an ETF.

ETFs Part 4: What’s inside an ETF?
ETFs Part 2: The Evolution of ETFs

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