Some ETFs follow an index, some don’t, some are sector specific, some aren’t. They can be managed actively or passively... "there's an ETF for everybody".

Many have recommended a passive investment strategy on broad based index funds, such as VTSAX (mutual fund) or VTI (ETF). It’s simple and somewhat safe over the long term. To know more about this investing strategy, I recommend reading “The Simple Path to Wealth” by J.L. Collins. Top notch material.

But wait... how do ETFs work exactly?

ETFs are Funds, which means that, as for other types of funds (like Mutual Funds), they own underlying stocks.

ETFs are Traded on the stock Exchanges, which should mean that their price is determined by the market… but is it really? Isn’t their price supposed to be determined by the price of the stocks in the fund - or its NAV ?

An ETF’s NAV (Net Asset Value) is basically the value of all the underlying stocks it owns, divided by the number of  the ETF's outstanding shares.

Let’s take a look under the hood...

ETFs are bought and sold on the stock exchange and as such their prices are primarily determined by supply and demand, i.e. the market. So, if a specific ETF gains in popularity and has lots of buyers, the price of the ETF will go up. Which happens independently of the value of its underlying stocks.

An ETF trading at $100 could very well have a NAV of $98 (or $104), at least temporarily.

But here’s the catch: fund managers (the companies that create ETFs and decide what stocks the funds should hold) partner with what is called “authorized participants” (usually large banks) and give them the right to create new shares for the ETF (a mechanism called “creation”) as well as the right to “buy-back” or “destroy” said shares (a mechanism called “redemption”), and that's how they ensure the ETF's price is in line with its underlying assets.

An example: ETF trading at a premium

1. Suppose an ETF is trading at $100 and has a NAV of $98. The fund’s authorized participants (AP) will notice that the ETF is trading at a premium and they will want to benefit from this arbitrage opportunity.

How ETFs work: ETF at a premium, authorized participants buy the underlying stocks

2. So the APs buy the underlying stocks at their market price (i.e. an average cost per ETF share of $98).

3. The APs then trade those stocks with the ETF in exchange for some ETF shares (worth $100 per share). Now that the ETF owns more underlying stocks, it's NAV has increased to be more in line with the ETF's price.

How ETFs work: authorized participants trade the underlying stocks with the ETF stocks that they resell at market price, for a profit

4. Finally, the APs resell the ETF shares on the market, at the market's price ($100), and by doing so they make a profit of $2 per share.

The inverse works too: ETF trading at a discount

The inverse mechanics happen when the ETF trades at a discount (instead of at a premium), for example: if the NAV is $102 and the ETF's price is $100, then there’s still an arbitrage to be made. APs will buy the ETF from the market, trade them with the fund manager in exchange for some underlying shares. The ETF holds less underlying shares so it's NAV levels with its market price. The APs then sell the underlying share at market price ($102) and thus make a $2 profit by doing so.

Indirect but opposing effects on market prices

It is possible that, for some very large ETFs (holding many, many underlying shares) that have a high trading volume, the back and forth trades made during the "creation" and "redemption" phases mentioned above could have an impact on the share prices (of the ETF and inversely of its underlying stocks), which could accelerate the return to equilibrium (and I suppose, also possibly overshoot it).

During creation: because the supply for the ETF has increased (i.e. added more ETF shares on the market), the ETF’s share price may go down, while the price of the underlying stocks may go up because their demand has increased.

During redemption: for the fund, it's as if they were a company buying back their shares, which usually has the effect of increasing their stock's price (lower supply). The underlying shares however have an increased supply which could push their prices down.

Keeping it oiled

This mechanism is fully regulated by the fund’s APs that can profit from the arbitrage, which works as an incentive to ensure the ETF’s price remains close to its NAV. What's great for the fund manager is that they don't have to pay for this process or even intervene at all, and can focus on what really matters (i.e. picking the right stocks to hold in the fund).

So... who pays for it?

The profits the APs make must come from somewhere, right? Right. No free lunch and all that.

The truth is, investors in the ETF are actually the ones paying the bill. When the ETF trades at a premium, buyers of the ETF are obviously the ones paying for that premium. But when the ETF trades at a discount, sellers of the ETF pay for the discount as they sell for less than they could have sold if they held the underlying stocks instead of the ETF.

But don't go closing your ETF positions just yet. Even if you bought an ETF at a premium and even if you sold it at a discount, it would not have necessarily been a bad investment. The alternative, if you wanted to replicate the ETF's performance, would have been to buy all the underlying stocks (and re-balance them periodically, etc.) to track the index or the actively managed ETF, which would certainly not be worth the difference in ROI (return on investment).

A few last things to note:

  • APs are not forced to participate in the arbitrage. Funds usually work with more than one AP.
  • APs have to "create" or "redeem" ETF shares in batches, they can't just do a few stocks at a time.
  • APs actually bear some risk during the arbitrage procedure (as for example there may be delays and price changes while it is ongoing) which may explain why they sometimes don't participate.

Photo by Markus Winkler on Unsplash