How ETFs Work
How we know they keep pace with the index
I talked about how I keep roughly half of my portfolio in wide market index funds before, but there are many types of Index Funds.
Today, we’re going to talk about the specific type of Index Funds i own, ETFs.
How can we be sure they are worth what they say they are worth? How does its value and the price we pay for them in the exchanges stay neck-and-neck?
Let’s talk about ETFs and how they work behind the scenes.
What’s an ETF
Let’s have Investopedia define the term for us:
An exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same as a regular stock. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.
In other words, ETFs are funds whose value corresponds to the value of whatever it is tracking.
For example, we could make a Coca-Cola ETF that tracks the value of Coca-Cola shares. If Coca-Cola shares go up, the value of the ETF would go up, if they go down, the ETF would go down as well.
But that brings the question… Why would we buy an ETF instead of just buying Coca-Cola shares directly?
Well, the simplest reason is that we don’t just want to track the value of Coca-cola, but of a large group of shares and companies at the same time. This adds additional overhead, effort, and transaction fees.
By purchasing a single “Index” we can have a single transaction fee, and let the fund managers worry about making sure we’re tracking the Index closely.
This simplicity, alongside the lower costs involved with ETF management means that they are a cost-effective and low effort way of investing for the average person.
What’s the difference between ETFs and Mutual Funds?
If you’ve been paying attention so far, you’ll notice that a lot of what we’ve been discussing in regards to ETFs also apply to Mutual Funds.
Mutual Funds as you know are also investment vehicles that allow investors to buy “shares” in the fund, which often tracks an Index.
What’s the difference here?
Well it’s actually in the name, while mutual funds can be purchased, they are not traded on exchanges, and so the mechanism from which an investor can buy and sell them is different.
When it comes to mutual funds, investors buy and sell the funds share directly to the company managing the fund, and they receive back the Net Asset Value of the share of the fund at the end of the day in which they sold them.
Effectively, they turn in their Mutual Fund shares for the value of the index it is tracking, which they receive from the company managing the mutual fund, who in turn sells the appropriate amount of underlying shares to pay the investor.
On the other hand, when it comes to ETFs, Investors buy and sell the ETF shares directly to other investors, and don’t hand them over to the fund manager to receive the NAV.
But of course this presents a problem… After all, if in ETFs the investors aren’t turning in the ETF shares to the management company, how does the value of the ETF on the exchange keep pace with the index?
Authorized Participants and Liquidity
The answer to that question is Authorized Participants.
To put it simply, while the general public isn’t allowed to turn in company shares and get ETF shares from the fund manager, certain organizations like banks, hedge funds, Market maker firms, etc… are allowed to do that.
These are firms that have an easier time acquiring both capital, and the shares corresponding to the index at a low cost.
This means that the Fund administrators don’t have to worry about transaction fees involved with buying and selling the shares themselves, and instead they effectively outsource that task to the cheapest option available.
Furthermore, the Authorized Participants are allowed to turn in ETF shares and get the corresponding amount of individual shares.
In effect, this means that if the price of the ETF diverges from the price of the underlying, these authorized participants have a chance to make money out of the difference.
How? It’s quite simple, and there are only 3 options:
The price of the ETF and the value of the shares are the same
The price of the ETF is greater than the value of the shares
The price of the ETF is less than the value of the shares
In the first option, nothing happens, and the ETF is tracking the index accurately.
In the second option, the Authorized Participants turn in shares to the fund manager, receiving ETF shares which they proceed to sell at the market for a profit equal to the difference between the value of the shares and the price of the ETF.
In the Third option, the Authorized Participants purchase ETF shares, and turn them in to the fund manager receiving the companies shares in return, which they proceed to sell at the market for a profit equal to the difference between the value of the shares and the price of the ETF.
This constant buying and selling provides sufficient liquidity and stability to the market, meaning that investors can be certain that the ETF shares and the value of the Index will be very close to each other.
In Summary
ETFs are cost effective ways to invest in Indexes because by combining low cost management with competitive liquidity providers they can reduce the management costs and fees below what regular mutual funds charge.
This means greater and more accurate tracking of the index, and ultimately more money in your pocket.
Let me know what you think!
And as always, if you have any questions or comments, shoot them on Twitter @TiagoDias_VC or down below!
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