How do ETFs work?

14 October 2016 | Portfolio construction


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You've probably heard exchange-traded funds (ETFs) described as baskets of securities that can be bought and sold like equity shares. But have you ever wondered about the mechanics that enable ETFs' trading flexibility?

Rich Powers"There are two key concepts to understanding what makes an ETF work," said Richard Powers, head of ETF product management in Vanguard Portfolio Review Department.

"First, creation and redemption, the process by which ETFs are bundled; and second, the role of authorized participants [APs], the parties that transact in that process," he said. "The resulting price convergence between an ETF and its respective basket of securities is what facilitates intraday trading of ETFs."

What is an ETF?

Very simply, an ETF is a wrapper, a vehicle that contains not only a basket of securities, but also a philosophy and process to invest stock or bond holdings. From this perspective, ETFs and mutual funds are the same.

For example, whether you purchase a FTSE 100 Index fund through a traditional fund or an ETF, you're investing in the same underlying securities. Both investment vehicles will hold all (or most) of the 100 shares in the same proportion as the index the funds seek to mirror.

How are ETFs and mutual funds different?

The most important difference between ETFs and mutual funds is how you buy and sell them. In other words, they are more similar than different.

"The E and T in ETF stand for exchange-traded," Mr. Powers noted. "That is, ETFs can be bought and sold throughout the day, the same way stocks are traded on a market exchange. While the F stands for fund, as in mutual fund."

This intraday liquidity offers flexibility and greater control over when and at what price you can trade ETFs. In contrast, mutual funds trade once a day, at the end of day.

Balance supply and demand with creation and redemption

The creation and redemption mechanism and the role of APs are two key concepts that enable ETFs' intraday liquidity. Creation and redemption is the process by which ETFs are packaged and deconstructed.

Authorised participants, typically large institutional investors, create and redeem the baskets of securities. These market makers play an integral role in supplying liquidity and keeping ETF prices aligned with the market value of the underlying assets throughout the trading day.

When rising demand causes ETF prices to rise higher than the value of the ETF holdings (i.e., trade at a premium), the role of APs is to buy the underlying securities, exchange them for ETF shares, and then sell those shares into the market. Conversely, if falling demand causes ETF prices to trade too low (i.e. at a discount), an AP may buy shares of the ETF in the market and redeem them in exchange for the underlying securities.

"When the value of the underlying securities increases, so should the value of the pooled security, whether a mutual fund or an ETF. These arbitrage activities among authorised participants help keep ETF prices aligned with the market value of the basket of securities," said Mr. Powers.

Look under the bonnet

ETFs offer an attractive and efficient way for investors to implement an investment strategy. So do mutual funds. The broad diversification and low-cost feature of ETFs are characteristics that can be tied to their index-based structure. So before you decide on an ETF or a traditional mutual fund, focus your research on investment objectives and your need for trading flexibility. Because whether you decide to go with an ETF or mutual fund invested in the same strategy, chances are you'll find the same securities when you look under the bonnet.

Important information:

This article is directed at professional investors and should not be distributed to, or relied upon by, retail investors.

This article is designed for use by, and is directed only at, persons resident in the UK.

This article was produced by Vanguard Asset Management, Limited. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

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 or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

The opinions expressed in this article are those of the individual author and may not be representative of Vanguard Asset Management, Ltd.

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


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