ETFs can be bought and sold on an exchange like ordinary shares. Investors can purchase or sell them through their brokers during trading hours. Unlike shares, however, they do not list on the exchange via an initial public offering. Rather, ETFs rely on a creation/redemption mechanism. Understanding how this mechanism works is the key to understanding the benefits and potential risks of ETFs.
The ETF market has three primary participants
- ETF issuers – Fund manager which manages the ETF and its underlying securities.
- Authorised participants (AP) - Institutions authorised to create and redeem ETFs.
- Market makers – Providers of liquidity by facilitating trades on the secondary market.
To purchase an ETF, a buy order can be placed into the market through a broker. This buy order can be executed by matching it against a sell order, much like the way ordinary shares are traded on the market. These trades will be facilitated by market makers who provide quotes throughout the day.
At this point, the ETF issuer is not involved in the transaction at all. The ETF issuer does not know that you have bought the units, nor does it receive any funds to invest. Units simply transfer in the secondary market from one investor (the seller) to another (the buyer) and go through a securities exchange two-day settlement process.
However, a scenario may arise where there is no ready seller in the secondary market, and demand exceeds what is currently available to trade. In this situation, market makers will request the issuance of units (i.e creation of new units) by authorised participants. To create new units, an AP enters the market and buys the securities in the creation basket at the percentages according to the underlying benchmark. The AP then delivers this basket of securities to the ETF issuer in exchange for an equal value of units in the ETF. The market maker then acquires these ETF units from the AP, and then proceeds to offer them on the market.
The process also works in reverse for redemptions. That is, if the AP has a block of ETF shares to sell, they will receive a basket of underlying securities, from the ETF issuer to sell, and the funds raised are used to redeem the ETF.
Several factors influence an ETF’s price, including the movements of the underlying securities, exchange-rate movements (for international investments) and investors’ demand for the ETF. The ETF issuer calculates and publishes the ETF’s net asset value (NAV) daily. The published NAV is based on the underlying securities’ closing market prices, minus the ETF’s fees.
From time to time, mis-pricing in the market may occur. For example, if there are many more buyers than sellers, the price of the ETF can go up by more than the true value of the underlying securities. This could be an opportunity for arbitrage by market makers and APs, knowing they can buy the underlying securities and create new shares of the ETF at fair value while selling them to investors at a price above this.