Investing

How Do Exchange-Traded Funds Work?

In general, exchange-traded funds are not bought from or sold back to the fund company like mutual funds. Investors can only buy or redeem shares directly from the ETF in blocks (typically 50,000 shares), and even then, most funds require in-kind transactions. With an in-kind transaction, the investor does not get cash when they redeem their shares; they receive the underlying stocks. In practice, this means that only institutions and the very wealthy can afford to deal directly with the ETF. Retail investors purchase ETFs through a broker on the exchange.
Institutional investors buy or redeem shares directly from the ETF in large blocks.
ETFs do not necessarily trade at the net asset values of their underlying holdings.

How trading relates to the net asset value

Unlike mutual funds, ETFs do not necessarily trade at the net asset values of their underlying holdings. Instead, the market price of an ETF is determined by forces of supply and demand for the ETF shares. To a large extent, the supply and demand for ETF shares are driven by the underlying values of their portfolios, but other factors can and do affect their market prices. As a result, the potential exists for ETFs to trade at prices above or below the value of their underlying portfolios.

However, by permitting large investors to buy or redeem shares in-kind, ETF sponsors have created a mechanism that should, in theory, help prevent sustained price-to-NAV discrepancies from opening up.

If an ETF traded at a discount to its net asset value, institutional investors could assemble 50,000-share blocks in the open market at the discounted price, redeem them for the underlying stocks and sell those stocks at a profit. The arbitrage opportunity is intended to generate sufficient demand for the discounted ETF shares to close the gap between their market price and the net asset value of the underlying portfolio.

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