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A Plain Talk guide to ETF terminology

08 November 2016


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ETFs can be a great way to achieve cost-effective access to core equity and bond markets. However, many investors are put off by the jargon that surrounds the ETF industry. This guide is designed to help you understand key ETF terms, giving you greater confidence to use ETFs to help you meet your goals.

ETF characteristics  

An ETF or exchange traded fund is a marketable security that trades like a common stock on a stock exchange but also has many of the characteristics of a mutual fund. ETFs allow investors to gain access to a diversified underlying portfolio via one quoted security. ETF prices change throughout the day as they are bought and sold.

The average daily volume (ADV) of an ETF is the average volume of shares traded in a day. There is a relationship between trading activity and liquidity: when average daily trading volume is high, the stock can usually be easily traded and is deemed to have high liquidity.

Over-the-counter (OTC) is a term used to describe securities that are traded in some other manner than on a formal exchange such as the London Stock Exchange. The most common form of OTC trading is done bilaterally with a broker.

Liquidity is a measure of how easy it is to trade ETF shares. It's a function of factors such as the spread and the average daily volume. As ETFs are open ended their shares can be created and redeemed as well as being traded on a secondary market. For larger investors, it's also possible to unlock liquidity through an authorised participant (AP) which might not be immediately obvious based on secondary market volumes.

Key Players  

An ETF provider is a company that offers ETF products – such as Vanguard. ETF providers are responsible for designing the products, managing the underlying portfolios and marketing them to appropriate investors.

Authorised participants or APs are large investors, such as broker-dealers, who enter into a contract with an ETF provider allowing them to create or redeem ETF shares with the fund directly. APs play an important role in keeping an ETF's share price close to its net asset value via the process of arbitrage. Generally, investors prefer ETFs to have several APs because competition between APs is likely to keep the ETF trading close to its fair value. Market makers are broker-dealer firms who take the risk of holding securities (known as inventory) in order to facilitate the trading of or "make a market in" that security. Each market maker competes for orders by displaying buy and sell prices for guaranteed volumes of shares. When they receive a buy order, they either match it to an offsetting sell order or sell securities from their inventory. And vice versa for a sell order.

Pricing  

The ask price is the price that sellers will accept for their ETF shares. ETFs are dual-priced, with the other price being the bid price. ETF investors buy ETF shares from a stockbroker at the ask price; sellers receive the bid price. The ask price is higher than the bid price and the difference (called the spread) goes to the broker.

The bid price is the price that the seller of an ETF share receives from a stockbroker. A bid-ask spread is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it.

Market value is the current value of an ETF's shares in the market. It will usually be close to, but not exactly the same as, the ETF's net asset value.

Net asset value (NAV) is the value of a fund's net assets (assets minus liabilities) per unit or share. For example, if a fund has assets of £1bn, liabilities of £100m and one million shares, the NAV would be (£1bn-£100m)/1,000,000 = £900.

When the market value of an ETF is above its net asset value, it's said to be trading at a premium. When the market value is below the NAV, the ETF is trading at a discount.

ETF mechanics  

Arbitrage is the process by which authorised participants (APs) help to keep the price of ETF shares close to the ETF's net asset value (NAV). If demand for an ETF exceeds supply, the ETF price is likely to rise above the NAV, creating a premium. In this situation the AP will typically create new units in the ETF with the ETF provider, delivering the underlying securities and receiving ETF shares in exchange and then sell the ETF shares in the secondary market for a profit. This process acts to close the gap between the ETF price and the NAV. If supply exceeds demand, the process happens in reverse: the AP redeems ETF shares with the provider, receiving underlying securities in return.

The creation mechanism is one of the ways in which authorised participants reconcile the differences between net asset value (NAV) and the market value of the ETF shares. It works by APs delivering the underlying securities and receiving ETF shares if the ETF is priced at a premium to NAV. This important mechanism helps to keep the ETF price close to the NAV.

A creation unit is the denomination of securities that can be created directly with the ETF provider. For example, one cre/ation unit could equal 100,000 ETF shares.

The redemption mechanismt value (NAV) and the market value of the ETF shares. It works by APs delivering the ETF shares to the issuer and receiving the underlying securities in return, capturing the difference between the selling price of the ETF shares and the underlying securities.

Trading  

There are two principal ways to trade ETF shares: on the primary market and on the secondary market. The primary market is where large investors create and redeem ETF shares with the ETF provider. The secondary market, meanwhile, is where investors buy and sell existing ETF shares on the exchange.

A market order is a common order type. It's an order to buy or sell at the best currently available price. Because there are no upside or downside limits, a market order usually ensures immediate execution. However, investors might end up trading at a variety of times and prices in some circumstances, such as if the order is large and/or the markets are volatile.

Limit orders are a popular way of placing limits on trading prices – for example, if an investor does not wish to sell below a certain price, or buy above a certain price. The investor states the number of shares being traded and the price limits, together with a time limit. If the trade can't be executed within the limits stated, it is cancelled.

A stop order is an order to buy or sell a security when its price passes a particular point. It can be used, for example, to limit downside (by selling when the price falls below a certain point) or to lock in profit (by selling when the price rises above a certain price).

Block trade – a way to execute large trades outside of the open market, in order to lessen the impact on the market. Block trades take place at an arranged price between the parties concerned.

The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

ETF shares can be bought and sold only through a broker and cannot be redeemed with the issuing fund. Investing in ETFs entails stockbroker commission and a bid-offer spread which should be considered fully before investing. The market price of ETF shares may be more or less than net asset value.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.