Exchange Traded Funds Basics
Exchange Traded Funds (ETFs) are investments that represent a diversified group of companies (just like mutual funds) but trade like stocks. You can think of ETFs as a cross between mutual funds and stocks. They’ve been around since about 1993, which is a short time for an investment product.
The ETF market has exploded since then; as of this writing, there are over 1,500 ETFs on the market. Similarly, in the past decade we have seen the emergence of new types of ETFs besides equity-based (stock based) ETFs and fixed income (bond-based) ETFs. There are now ETFs based on commodities, ETFs based on currency and ETFs based on real estate, just to name a few. In recent years, ETFs have been known to make up as much as 30% of the daily traded volume on U.S. exchanges.
How ETFs Work
To get a better understanding of how ETFs work, let's look at ETFs that track a specific index. For example, the SPDR S&P 500 (SPY) exchange-traded fund tracks the S&P 500. What do we mean by "track"? When a fund "tracks" an index, it holds all of the stocks in that index; a fund that tracks the S&P 500 will hold stocks in all 500 of the individual companies in the S&P 500.
The fund will not hold an equal amount of all 500 stocks, but rather a weighted-average of all 500 stocks (which essentially means that the fund invests a higher amount in the stocks that make up higher percentage of the index's total value). An investor can buy shares of the exchange-traded fund; the price of each share is equal to the total value of the fund divided by the number of shares outstanding.
But wait, isn't that the same thing as a mutual fund? After all, you can buy shares of an index mutual fund that tracks the S&P 500 or other indices. A mutual fund and an ETF can represent the same underlying portfolio.
In fact - as we said earlier- an ETF is very similar to a mutual fund. However, there are key differences between ETFs and mutual funds, and these differences stem from the fact that ETF shares are traded like stocks, on exchanges through a broker. An investor who wants to buy or sell mutual fund shares, on the other hand, must do so through a fund manager, and the fund manager will only execute that trade at the end of the trading day (no matter what time that day the investor placed the buy or sell order).
The stock-like nature of ETFs provides some other key benefits as well. However, an ETF trader will have to incur many of the same fees that are associated with trading stocks, such as brokerage commissions. The advantages and disadvantages of ETFs are discussed in greater detail in their respective sections on this website.
Creation, Redemption & The Authorized Participant
The Authorized Participant (AP) is an institutional investor that "creates" ETF shares and ensures that the ETF shares accurately reflect the per-share value of the underlying portfolio.
Let's say that you want to buy 1,000 shares of an ETF that tracks a basket of three stocks: Apple (APPL), Google (GOOG) and Facebook (FB). However, there are only 500 shares of this ETF available in the market.
It is the AP's job to "create" 500 new shares. First, the AP buys APPL, GOOG and FB shares (in the correct proportion based on weighted average value) on the open market. He will deliver the collection of APPL, GOOG and FB shares to the ETF issuer, and in return the AP will receive 500 new shares of this ETF. The AP then goes and sells these ETF shares on the open market. And just like that, there are now 1,000 ETF shares available on the market, whereas before there were only 500.
It is important to understand how the AP profits in this scenario. When you placed your massive buy order of 1,000 ETF shares through your broker, the demand for these ETF shares increased and - as a result- so did the price of the each ETF share. At this increased price, each ETF share was worth MORE than the per-share value of the underlying basket of stocks (the per-share value of the underlying security basket is known as the fair-value price).
But remember that the AP first bought the APPL, GOOG and FB stocks on the open market at fair value and gave them to the ETF issuer in exchange for 500 ETF shares. The AP then went to the open market and sold the 500 ETF shares that he received and -due to the increased demand that your massive buy order caused- the AP was able to sell the ETF shares at a price higher than fair value (in other words, the AP is able to sell the ETF shares at a price higher than the per-share value of the underlying portfolio).
The AP can also profit when the ETF share price falls below fair value.
If there is a large sell order on this same ETF, then the price the of ETF shares falls relative to the per-share value of the underlying APPL, GOOG and FB stocks. The AP will go buy these ETF shares in the open market at the reduced price. The AP then goes to the ETF issuer and gives the issuer these ETF shares. In return, the AP gets a basket of APPL, GOOG and FB stocks, which, collectively, are worth more than the ETF shares that the AP redeemed with the ETF issuer.
The AP & Me
The Authorized Participant's actions are important for two reasons. The first is that the ETF share price will only be above or below fair value temporarily. As we saw earlier, the minute the ETF share price rises above fair value, the AP will go and create new ETF shares (through the ETF issuer) and sell them on the open market for a quick profit. Eventually, the increased supply of ETF shares will lower the price of each ETF share until it equals fair value (at which point the AP will no longer profit from these actions and will stop creating new shares).
Similarly, the minute the ETF share price falls below market value, the AP will start buying ETF shares and redeem them through the ETF issuer. The increased demand for the ETF's shares (due to the AP's sudden purchases) will drive up the price of the ETF until it reaches fair value. As a result, the AP's actions that the ETF shares are almost always trading at (or near) fair value.
Secondly, note that the ETF issuer is not the one creating shares. The AP is the one buying all of the shares that will make up the security basket, and the AP is the one calculating how many shares of each company the security basket will hold.
As we will see in the next section, this creation/redemption process directly impacts how much you -the investor - will pay to trade ETFs.