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How exactly do ETFs work



January 31, 2008 – Comments (5) | RELATED TICKERS: SKF , SRS , GLD

To give due credit, most of this was originally mentioned by UCLAgrdstnt (in response to a pick of SKF by Intelledgement).  I read all of Intelledgement's response, but I'm hoping to get a more definitive answer to a couple of points.

1) If an ETF is supposed to track and index, or the inverse of an index, or double an index's daily performance or double the inverse of an index's daily performance how exactly is that supposed to work?  I don't mean: how do the manager's get that to happen.  Rather, since the ETF trades like a stock with supply and demand dictating the bid/ask prices, doesn't this mean that the ETF tracks investor's sentiment of how they think the index is going to perform rather than how it is actually performing? 

So which is it?  Does the ETFs trade like a stock and supply/demand dictate the pricing or is it based on how the index performs.  I think it has to be some kind of combination (like the market maker keeps the bid/ask somewhat around the NAV of the ETF but the market will determine the pricing within a certain acceptable range).  But that is just my opinion.  Does anyone know what the 'truth' is?

2) How are expense ratios deducted from ETFs.  Obviously the management is getting paid (as they should, more so with some of the more exotic ETFs out there).  Obviously they are not saying that we're collecting our fee on such and such a date each year or month.  So how do they skim their portion over the course of time?  I don't think they can be getting a cut of each transaction, but anything is possible.  The fee has to be reflected in the price of the ETF over the course of time somehow.  I'm thinking of ETFs that track indices or commodity prices mainly, but I would think this problem would apply to any ETF out there. Anyone have any insights on this?

Responses will be greatly appreciated.




5 Comments – Post Your Own

#1) On January 31, 2008 at 8:56 PM, AnomaLee (28.60) wrote:

ETF's are similar to mutual funds. They are large lots of shares that are grouped together and then sold in large lots of shares themselves. 

To answer the question to number one. You're right. The shares of the ETF differ from the underlying assets due to supply & demand at any given point and time. The only thing that keeps shares from deviating too far from the underlying assets is that ultimately the shares can only ben redeemed in large lots (50,000 or more) from the fund at the price of the underlying assets. The value of the underlying assets is called NAV (Net Asset Value) and is calculated constantly and is easy to look up. There are rare occassions where the ETF will trade exactly on par with its NAV which give a Price:NAV ratio of 1. Anything higher than 1 means the price is overvalued and vice-versa.

The only thing that supposedly keeps a Price-NAV ratio humble is the fact that the big money controls the daily fluctutions of the market and if they want to redeem/cash in the shares they will only want to do so when the NAV is less than 1. That supposedly increases demand in shares and sellers raise their prices.

In reality if you are buying an ETF you are buying it from your broker. That's the case for ETF's and basically most of the stocks you buy. Typically, the brokers and their floor traders buy large lots of stocks, ETFs, etc. and then go and sell them at varying price to their customers at varying prices according to the market. That's one way your broker makes money off you as well as commissions, interest on borrowing, and other kinds of financial instruments.

To answer question number two. Well, typically the group that manages the fund charges a commission whenever they sell or have to redeem a share. That price is then tacked on to the price of the stock and is calculated into an expense ratio. Unlike mutual funds, ETF's are usually not actively managed. So, they are usually grouped together in the same proportion of shares of the underlying assets, then the ETF shares are grouped into a lot of 50,000 shares(or more) and sold, and that's when they charge a commission to the buyer to pay for their mortgages, commission fees to buy the underlying stocks themselves, and to make a profit of course! --- And then that cost is passed along. That is also how you will see the value of an ETF grow. It's not because the stocks themselves are rising, but because there is more people buying that particular ETF.

With most mutual funds everyone has the right to redeem the market value of their shares at any given time. You are normally charged a commission from the mutual fund, as well as your broker, and you may be charged a penalty for any holding violations.  A certain percentage of a mutual fund is usually held in cash as a reserve or for future purchases. Every year some of this cash is withdrawn as a fee to pay for the management of the mutual fund. Also, when large amounts of mutual fund holders decide to redeem their shares the mutual fund may be forced to liquidate assets of the fund which usually causes a decline in stock prices since most mutual funds $400 million - $10 billion+.

So, why do people prefer ETFs? Because, they offer an inexpensive way to diversify risk and they are convinient and usually a very cost-effective way to invest in an idea.

Personally I think that ETF's help to stabilize market prices at times. Good question. I had to look this up when I first wanted to buy an ETF. I hope this helps. I even used Google to help remember certain facts and added my own "insight" into how they are used.


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#2) On February 01, 2008 at 8:53 PM, floridabuilder2 (98.60) wrote:

holy cow anomalee......... why didn't you just blog that first... thanks

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#3) On February 04, 2008 at 1:00 AM, StockSpreadsheet (69.69) wrote:

One other thing that can keep the value of the ETF's close to the value of the underlying shares is dual trades.  This can only be done by big money institutions or individuals as it takes a lot of money to do.  Basically, if the value of the ETF exceeds the value of the underlying shares, some big money entity can sell the ETF and then buy an equivalent value of the underlying stocks.  The reverse would happen if the ETF is below the value of the underlying stocks.  These trades, over time, will tend to keep the value of a basket of stocks, such as an ETF, relatively close to the index that it is supposed to track and to the value of the underlying shares within the ETF. 


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#4) On February 05, 2008 at 4:14 PM, abitare (30.15) wrote:


Not looking good for you staying in positive territory. I will check the tarot cards again.



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#5) On February 05, 2008 at 6:16 PM, bridgeboy0 (29.16) wrote:


Not looking good for you getting above 55% accuracy.  Perhaps if you can find 200 straight winners, you'll be able to do it.

My score swings up and down very fast.  If the market gets hammered (like it did yesterday and today) then I lose points by the hundreds.  If the markets perform like they did last week, well then I gain points by the hundreds.  We'll see how all this turns out.

What I do know, is that thanks to my accuracy, I only need to be positive about 200 points to be ahead of you.  So no matter what your tarot cards say, when (not if, but when) the markets pick up you'll know where to find me.


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