Find out more about how ETFs are traded and the major players involved.
The ETF market is actually divided into two markets: In the primary market, shares are created and redeemed in batches by large institutional finance houses in conjunction with the ETF fund manager. In the secondary market, ETF shares are traded (bought & sold) on the stock exchange.
Unlike traditional mutual funds, there are additional participants involved, other than just the Fund Manager. These Authorised Participants and Market Makers ensure liquidity by creating and redeeming shares and reducing the burden on the Fund Manager. Thus ETF’s have resulting lower annual costs compared to mutual funds.
Authorised Participants are the large institutional finance houses, who can create and redeem shares directly with the Fund Manager.
Only Authorised Participants can do this. They apply for new ETF securities to be created in large “creation units”, one of which is usually equivalent to 100,000 shares. In return AP’s provide an amount of securities equal in value or cash equivalent to the Fund Manager. The AP’s are then issued the ETF securities, which they can then sell on the secondary market i.e. the stock exchange.
The Stock Exchange provides buyers and sellers the platform to trade ETF securities.
Market Makers provide liquidity in this secondary market by adjusting prices based on the continuous market movement of the underlying ETF securities.
At least one Market Maker is assigned to actively quote the ETF. Market Makers are members of the Stock Exchange and are subject to Stock Exchange rules and regulations.
Market Makers set intra-day bid prices and offer prices, whereas the ETF Fund Manager calculates the Net Asset Value price of the ETF once a day.
As an aside, note that some Market Makers are also Authorised Participants, but not all.
In order to understand the mechanism of arbitrage, it is important to understand the concept of pricing and spreads. ETFs are bought and sold on the secondary market at a market price. The issuer of the ETF calculates the Net Asset Value or NAV price of the ETF daily, basing this on the market prices of all the underlying securities (after fees and expenses of course). Consider the price of a sandwich being based on the prices of all the individual ingredients, a smoked salmon sandwich will have a greater price than an egg sandwich, even after packaging costs have been deducted. The market price for an ETF can be affected by the share price movement of the underlying stocks, investor demand, currency movements if the ETF invests overseas. Thus the market price can differ from the calculated NAV. Luckily, market participants behind the scenes help to ensure that it rarely diverges much from the NAV. More on how later! The spread is the difference between the bid price and the offer price. The bid price is the purchase price i.e. the price participants in the secondary market are willing to pay for a bundle of shares The offer price is the sale price i.e. the price participants in the secondary market are willing to sell a bundle of shares for. The difference is the spread. It is up to the Market Maker to ensure that spreads remain within a certain range. The Market Maker earns revenue from trading. Wider spreads result in a reduced demand for ETFss and so the Market Maker is always keen to keep spreads tight, in order to ensure large trading volumes. There are several ways that ETF share prices can be kept in line with the NAV price, thus keeping spreads under control. ‘Arbitrage’ is one of these mechanisms. An arbitrage opportunity crops up when the price of an ETF share moves from the value of the underlying securities. Behind the scenes, market participants calculate the value of the ETF securities continuously throughout the day. If the ETF price is higher than the NAV, then arbitragers step in. They buy the underlying securities and exchange them for new ETF securities, before selling these on to the primary market for a profit. If the ETF price is lower than the NAV, again arbitragers step in. And buy ETF securities on open market, redeem them for the underlying securities, and then sell the individual securities on for a profit. The effect of arbitrage trades is to push indexes, equities and ETFs back in line. Another important distinction to get to grips with when dealing with ETFs is the difference between ‘physical and synthetic’ ETFs. Basically the physical index physically holds all (or a representative sample of) the constituent securities of an index. Just like other types of indexed funds. Synthetic ETFs use sophisticated financial instruments called TOTAL RETURN SWAPs to track an index. Rather than physically holding the underlying securities, a swap, involves entering a contract with a counterparty, who then pays the return of the chosen index in cash.