How ETFs work
ETFs trade on SETS which combines the benefits of order-book trading with market maker support.
The operation of ETFs can be separated into three distinct flows or transactions:
- The Market Maker purchases a basket of shares (in the stock), as specified by the ETF custodian, for cash.
- This basket of securities is then exchanged with the ETF custodian for a set number of ETF units or shares (creation).
- The Market Maker then has an inventory of ETF shares through which to satisfy market demand for buy/sell orders.
Redemption is simply this process in reverse whereby a Market Maker will swap a defined number of ETF shares with the ETF custodian for the underlying basket of shares, which can then be sold for cash in the secondary market.
Price formation and tracking error
The key difference when comparing ETFs with ordinary shares is that price formation has nothing to do with market supply and demand, but rather the creation/redemption process as described above.
Two factors ensure accurate tracking of the relevant index:
- Authorised market participant, including arbitragers (those that look to make risk free profit from market pricing errors), can create/redeem ETF shares.
- Market participants are able to short sell ETF shares (sell stock they do not actually own).
Consequently any deviation of the ETF away from fair value creates the opportunity for risk free profit. In this way, the ETF trades very close to NAV with minimal tracking error throughout the trading day.
Income and management charges
As with an ordinary share, dividend or interest income is accumulated within the price of the ETF and then paid out, either on a quarterly or bi-annual basis. It is from this income payment that the ETF management charges (typically 0.2-0.75%) are deducted.