Author Topic: ETF pricing and liquidity  (Read 1903 times)

Dago

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ETF pricing and liquidity
« on: February 11, 2016, 12:42:18 PM »
Hello,

I am not sure how the ETF pricing exactly works. I understand that people trade it the same way as a stock. However, where are new shares emitted ? Surely if there are more and more people who want a certain ETF, there will be more shares ? otherwise the price would become unrelated to the underlying index.

Thank you in advance for your explanations.
Barth

Proud Foot

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Re: ETF pricing and number of shares
« Reply #1 on: February 11, 2016, 01:01:22 PM »
I think this explains and answers your questions in a way that is easy to comprehend.

https://www.vanguard.com.hk/documents/etf-how-etfs-work-en.pdf

Edit: To answer your question about demand, shares, and price, if the price of the ETF moves so it is unrelated to the underlying index then there would be the chance for arbitrage.  Look at VTSAX and VTI, both had the same underlying expenses and holdings. If the price of VTI exceeds the underlying NAV you would want to invest in VTSAX.  The same thing would happen in the opposite if the price of VTI dips below the underlying NAV (I imagine this would be extremely rare).  Because of this and how ETF's are structured, if the price were to become unrelated to the underlying index it would not last for very long as the marked would correct to bring the price in line with the underlying index.
« Last Edit: February 11, 2016, 01:13:05 PM by Proud Foot »

Dago

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Re: ETF pricing and number of shares
« Reply #2 on: February 11, 2016, 02:18:59 PM »
Thank you very much, it explains exactly what I was asking.

Best regards,
Barth

BBub

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Re: ETF pricing and liquidity
« Reply #3 on: February 11, 2016, 02:54:15 PM »
Every ETF has a Net Asset Value (NAV) of underlying constituents at a given time.  You can see the NAV listed on the fact sheet for a given ETF.

The market price is usually very close to the NAV.  If the ETF trades at a discount, arbitragers will step in to buy shares then sell the basket of underlying holdings.  If at a premium, they'll short ETF shares & buy the underlying holdings.  The arbitragers are either market makers or super-sophisticated algo type shops.  Big volume, penny profits, not something to try at home.  In a nutshell, the free market system itself keeps the prices pretty close to parity.

It's not perfect, but it generally works out.  For example, the NAV of VTI closed yesterday at 93.70 and the market price was 93.68.

BBub

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Re: ETF pricing and liquidity
« Reply #4 on: February 11, 2016, 03:03:25 PM »
Just re-read your original question. 

Yes, ETF companies can issue new shares.  The fund company sponsoring the etf will buy up the underlying constituents, create new shares, then hire a market maker to release them into the market over time while also arbitraging the ETF to keep prices in line with NAV.  They use the same process in reverse reduce the share count.

MustacheAndaHalf

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Re: ETF pricing and number of shares
« Reply #5 on: February 11, 2016, 09:44:57 PM »
Just to reinforce that with some added detail, ETF shares are constructed in "creation units" of typically 1 million shares.  When an ETF is more valuable than it's contents, one of a few companies that have arrangements with Vanguard will buy those shares on the open market, communicate with Vanguard, and form 1 million new shares of the ETF.  They immediately sell those shares, profiting off the higher price of the ETF relative to it's contents.