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Chirag Pandya, ETF Capital Markets Analyst, Vanguard, talks about the underlying mechanics of investing in ETFs.

Transcript

From your client's perspective ETFs are really just another way to invest in a stock or bond market index fund, but the underlying mechanics are a little different. One way to think about how ETFs work would be that ETF providers outsource certain aspects of fund administration. That lets the ETF provider concentrate on doing a good job managing the investment portfolio within the ETF. This also means that the provider can set a lower annual charge for an ETF compared to a traditional fund structure.

In the traditional fund, the fund manager maintains a register of investors and handles all trades in the fund by creating and redeeming shares or units in the fund. With an ETF third parties take over these functions. These third parties, broadly called market participants, operation a primary market in ETF shares behind the scenes. Certain market participants can create and redeem ETF shares in the primary market, which can then be traded on the stock exchange in the secondary market.

So who are the market participants and what do they do? Let's start with the authorised participants. They're called authorised participants because they are authorised by an ETF provider to create and redeem large blocks of shares directly. Only authorised participants can do this. They are usually large financial institutions. This allows ETFs to grow and shrink in response to investor demand, just like traditional funds.

The other key market participants are market makers. Just as the name suggests, their primary function is to make a market. In other words, they quote prices at which they are willing to buy or sell ETF shares throughout the trading day, call it a bid price and an offer price for shares in a given ETF. This helps to ensure that ETF investors can always buy or sell their shares during market hours.

The price of an ETF stays pretty close to the NAV value of the underlying index portfolio for two reasons. First, if a market maker quotes too far away from the NAV other market makers or authorised participants in the primary market can benefit from the mispricing. If an ETF is overpriced compared to the underlying portfolio securities in the index an authorised participant can simply sell the overpriced ETF shares to buy the underlying securities and pocket the difference. This activity works to keep ETF share prices close to the NAV of the underlying securities.

Most of this activity happens behind the scenes in the primary market. Individual investors, your clients, would buy existing ETF shares that trade on the stock exchange. Market makers quote the prices they are willing to buy or sell on the electronic stock exchange. Stock brokers have access to these prices and can execute and settle trades for you and your clients for a fee. Some platforms also have stock broking functionality.

Many investors take great comfort in being able to invest at a known price. You can get prices at any time the stock market is open. You can even get free delayed ETF price quotes on a number of websites, including the stock exchange where the ETF is listed. You can also get a daily net asset value on the issuer's website.