ELI5: ETF Basics

Last week, we talked about how ETFs are not breaking the market. Today, let's take a step back and discuss some ETF basics, like the players involved, how they're created and how pricing works. But first, what exactly is an ETF?

ETF?

ETF stands for exchange-traded fund, they are funds that trade on an exchange (aptly named). An ETF tracks a sector or index by holding the underlying assets. The Vanguard S&P 500 ETF (VOO) for example, holds the 500 largest US stocks to track the S&P. This is one of the major benefits of ETFs, it allows you to own hundreds, even thousands of assets in a single fund.

ETFs can hold stocks, bonds, commodities or even a mix. An ETF is essentially an asset-filled "basket". Some baskets are pretty plain (such as VOO), some are more out there, such as the The Obesity ETF (SLIM) which holds and tracks companies profiting from the obesity epidemic. There's a basket for everything.

The ETF Provider and Authorized Participant 

The ETF Provider designs, brands and issues the fund. They come up with the themes, strategies and ultimately the assets held. The biggest providers are BlackRock, Vanguard and State Street. The ETF Provider makes money through the fund's management fee. The more money invested in their fund, the more money they'll make.

The Authorized Participant is responsible for buying the assets held in the fund. They are usually a large financial institution (i.e Goldman Sachs, JPMorgan Chase, etc.) that have a lot of buying power. They profit through an arbitrage (fancy word for price differences) process we'll discuss below.

The Creation & Redemption Process

To create new ETF shares, the Authorized Participant will buy the underlying assets and deliver them to the ETF Provider. In exchange, the Authorized Participant receives a block of ETF shares of equal value to the assets they delivered.

To think of it simply, the Authorized Participant delivers assets to the ETF Provider, the ETF Provider puts them in baskets, then gives those baskets back to the Authorized Participant to sell in the market. This is the creation process.

The process can also happen in reverse, where the Authorized Participant trades ETF shares back to the ETF Provider for the assets alone. This is the redemption process.

Price Correction Mechanism 

ETFs should reflect the value of the assets they hold. However, trading can cause fluctuations in an ETF's price and can lead to mispricing, where the basket of assets is valued differently than the assets themselves. This mismatch creates a profitable opportunity for the Authorized Participant.

If ETF demand is high, the basket of assets could be valued greater than the assets themselves. The Authorized Participant can jump at this opportunity to buy the underlying assets and trade them in to create more ETFs (more baskets!). Since they got the assets for cheaper than what they sell the baskets for, they earn a sweet risk-free profit! More sell supply leads to a lower price, so this increase in selling should move the ETF’s price downwards near its true value.

On the other hand, if ETF demand is low, the basket of assets could be valued lower than the assets alone. The Authorized Participant can buy the underpriced baskets from the open market and trade them back to the ETF Provider for the assets alone. Since the assets alone are worth more than the baskets they traded in, the Authorized Participant can sell the assets for a profit. More buy demand leads to a higher price, so this increase in buying should move the ETF's price upwards near its true value.

The Authorized Participant is extremely motivated to take advantage of these opportunities, which is great for maintaining the ETF's price integrity.

Conclusion

ETFs can appear complicated at first. There are quite a few layers to understand, but once you grasp the basics, you realize they're nothing more than baskets!