Whether you’re a seasoned investor or new to the markets, I believe the best thing you can do is arm yourself with a little knowledge, learning as much as you can about the present environment and how to navigate it. Like all things in life, a little knowledge goes a long way. Today I’d like to provide a lesson in exchange- traded funds (ETFs).
Let’s start at the beginning: What is an exchange-traded fund?
Exchange-traded funds, or ETFs, were introduced more than two decades ago. During that time, the average investor typically invested in individual stocks, individual bonds, and mutual funds. ETFs provided another avenue for people to participate in the market. The first ETF, and those that followed, were only invested in stocks. More recently, the marketplace introduced bond ETFs as well.
Put simply, an ETF bundles together select securities, such as stocks or bonds. Typically, the goal is to track a market index, such as the S&P 500; when we build ETFs, we look at the index as a guide for deciding which securities to include. The ETF is traded on an exchange, just like a stock. And, just like a stock, investors can buy and sell ETFs throughout the day at a price determined by the market. The price is usually aligned with the collective price of the ETF’s underlying stocks or bonds.
So why do people use ETFs? Why not just trade individual stocks? Well, for most investors, buying and selling individual securities, 10 shares here, 50 shares there, can be complicated and expensive. When trading an ETF, you’re essentially trading a bundle of securities—not just a few here and a few there—in one transaction. It’s simpler and cheaper. And, because the ETF is typically based on an index, buying an ETF gives your portfolio exposure to a number of companies. Instead of having to choose individual companies yourself, you’re instantly given access to a diversified portfolio in one trade.
How are ETFs created?
As I mentioned before, when we build ETFs, we typically look at an index as a guide for our investment selection. But who is “we”? “We” are ETF providers, such as BlackRock, who manages iShares funds. When we create a new fund, we first select a particular index. We use that index as a guide for what our new fund will be designed to track. We then launch the fund with a portfolio of securities that is designed to track that index. Large financial institutions called “Authorized Participants”, or “APs”, partner with an ETF provider such as iShares. The AP creates the initial fund shares, and then makes them available to investors.
The AP’s job doesn’t end here. It can also help to keep the ETF’s market price, and the prices of the underlying securities within the fund, closely aligned. They do this by maintaining the balance between supply and demand for the ETF on the exchange. For example, if demand for an ETF increases, its price may go higher than the price of the underlying securities. The AP then would likely seek to take advantage of this by buying those cheaper securities and creating additional ETF shares to sell to the market until demand is met and the prices realign.
If demand for the ETF goes down, and the price drops below the price of its underlying securities, the AP can reduce the number of shares in the market through a process called “redemption”: the AP buys the cheaper ETF shares, unbundles them, and sells the higher-valued securities back into the market until the prices realign. Here’s that scenario, known as “ETF arbitrage”, illustrated via side-by-side comparison:
While the buying and selling of an ETF is easy for investors—you simply enter a trade like you would with an individual stock—there’s a lot going on behind the scenes. Financial professionals work together to make this experience simple and seamless.
Want to see more from Matt? Take a closer look at ETF Mechanics: Creation and Redemption.