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ETFs Part 3: Behind the Scenes with ETFs

Find out who creates ETF shares and why.

Although the primary market for ETFs is closed to most investors (meaning that typical, retail investors do not transact directly with ETF sponsors), it is open to one very important market player: the authorized participant (or AP). APs are large institutional investors or clearing firms transacting directly with fund sponsors in exchanging ETF shares for their underlying holdings or the underlying holdings for ETF shares, often in large, standardized quantities of 50,000 ETF shares.

This process of exchanging baskets of securities and ETF shares is called in-kind creation/redemption. It is the reason ETF premiums and discounts are generally self-correcting. Deviations from NAV create profit opportunities for authorized participants, and as they conduct arbitrage trades, the APs help bring the ETF's market price into better alignment with its NAV.

As an example, let’s take the case of an ETF that is trading at a premium. First, an AP acquires the securities the ETF holds (or a representative sample of those securities, as specified by the ETF’s portfolio manager). Next, the AP delivers the securities to the ETF provider along with a creation/redemption fee set by the sponsor. In exchange the ETF sponsor forms a block of ETF shares formally known as a “Creation Unit” and delivers those shares to the AP. The AP can then hold those shares, deliver them to a large institutional investor or sell them in the marketplace. However since this is an arbitrage transaction, the shares will likely be sold. Selling the newly created ETF shares increases the supply in the market, driving down the price of the ETF (pushing it closer to its NAV), thereby reducing the premium that kicked-off the whole process.

Creating a basket is relatively straightforward when the securities making up the index that an ETF tracks are easily obtainable, As a result, ETFs tracking heavily traded, highly liquid markets like US stocks typically display only small premiums or discounts. A good example of this is an ETF like SPY, which tracks the S&P 500®. Historically, the market price of SPY has tended to stray no more than 0.05% or so away from its NAV1.

However ETFs that track less liquid markets (where it is more difficult to purchase the underlying securities) such as high-yield bonds, commodities, or emerging markets can display differences of 1% or more1. Such differences are usually due to lack of liquidity, though sometimes more complex factors are involved.

You can tell if an ETF is trading at a premium or discount by checking the "Quote Details" section for the ETF on Schwab.com, showing the premium or discount as a percentage of NAV for the previous day's close. Remember, it's the change in discount or premium that matters most. Moreover, these changes aren't necessarily a drag on performance — the effect can be either positive or negative depending on which way the discount or premium moves between a purchase and subsequent sale.

For example, if an international fixed income ETF trades with a somewhat persistent 0.6% premium to NAV, and you bought and sold the ETF at that same premium, there would be no effect on your return. The risk comes when that premium erodes or even becomes a discount during the time you own the ETF. In our example, if you bought the ETF while it was trading at a 0.6% premium but sold it while it was trading at a 0.4% discount, the change during the roundtrip would have cost you 1%.

Although realizing small gains or losses from potential changes in discounts and premiums might be acceptable in many cases, and possibly even unavoidable for certain ETFs, the main point is to be aware of the risks involved — and to be purposeful when trading ETFs that may exhibit excessively large or volatile discounts and premiums to NAV.

Now that 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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