Ad asked in Business & FinanceInvesting · 9 years ago

can someone explain to me how an ETF works?

for example the SPY , how exactly does it track the SP500 index , i thought that the price of an ETF moves just the same as the price of a stock does , supply and demand , therefore if the etf should be tracking the index then when the index rallies people would be buying the etf , but if that is how it works then i dont understand how anybody in their right mind could be selling the etf when index is rallying . am i completely missing something ?

4 Answers

  • Anonymous
    9 years ago
    Favorite Answer

    ETFs seem so simple. Buy the market just like you would buy a stock, follow its value continously during trading hours, and sell any time you like. There are rare capital gains distributions, and management fees are low.

    What seems so simple for the investor involves complex system of agreements between different kinds of financial players. The key innovation of an ETF is that it does not invest by purchasing stocks with cash on the open market like a mutual fund. Instead, an ETF is created through a private barter market in which ETFs are traded for stock certificates and redeemed in a reverse exchange.

    The whole process starts when a fund manager who wants to launch an ETF submits a detailed plan to the SEC for how the ETF will operate. Legally, ETFs sold in the US are governed by the same laws as mutual funds, and SEC approval is necessary. The fund manager handles all the paperwork and creates demand by advertising and promoting a new ETF.

    The next ETF player is the index provider, a firm which specializes in creating and maintaining indexes of stocks which represent attractive asset classes. S&P, Russell, and Dow Jones are among the best known. Clear procedures for determining the target must be published, and the net asset value of the index must be disseminated in real-time.

    The next set of players are giant investment houses which have large baskets of stocks available for exchange with an ETF certificate. Often they are closely tied to the fund manager. In practice big institutional money management firms with experience in indexing play this role, such as State Street, The Vanguard Group and Barclays Global Investors. They direct pension funds with enormous baskets of stocks in markets all over the world to loan stocks necessary for the creation process.

    The next set of players are authorized participants, also referred to as market makers or specialists. These middlemen borrow the appropriate basket of stocks and exchange them with the ETF fund manager for newly created ETF certificates.

    This so-called in-kind trade of essentially equivalent securities is the crucial innovation of ETFs. Because no cash traded hands, the government does not view this as a sale of a capital good. Many industries have this feature. In natural gas, for instance, one producer may exchange gas in a pipeline it owns on the West Coast for gas owned by another producer in a pipeline on the East Coast so that each may supply a customer without transporting the gas across the country. Because the in-kind trade of stocks for ETF certificates does not trigger capital gains, there are no (or rarely) capital gains distributions for investors.

    A minor player in all this is the custodial bank which protects investors at all times by holding assets for the fund manager. Exchanges are made in large amounts, sufficient to purchase 10,000 to 50,000 shares of the ETF in question. The custodial bank doublechecks that the basket represents the requested ETF and forwards the ETF shares on to the authorized participant. The custodial bank also holds the basket of stocks in the fund's account for the fund manager to monitor. There isn't too much activity in these accounts, but some cash comes into them for dividends and there are a variety of oversight tasks to perform. Some managers have leeway to use derivatives to track an index.

    There are also minor government agencies monitoring the activity. The flow of individual stocks and ETF certificates goes through the Depository Trust Clearing Corp., the same US government agency that records individual stock sales and keeps the official record of these transactions. It records ETF transfer of title just like any stock. It provides an extra layer of assurance against fraud.

    Once the authorized participant obtains the ETF from the custodial bank, it is free to sell it into the open market. From then on ETF shares are sold and resold freely among investors on the open market. Investors are the final player in this financial game.

    Redemption is simply the reverse. When demand for an ETF shrinks (investors are selling), an authorized participant buys a large block of ETFs on the open market and sends it to the custodial bank and in return receives back an equivalent basket of individual stocks which are then sold on the open market or more typically returned to firms which loaned them.

    The process might seem cumbersome but it does allow for transparency and liquidity at modest cost. Everyone can see what goes into an ETF, investor fees are clearly laid out, investors can be confident that they can exit at any time, and even the authorized participant's fees are guaranteed to be modest. If one allows ETF prices to deviate from the underlying net asset value of the component stocks, another can step in and take profit on the difference, so their competition tends to keep ETF prices very close to it underlying Net Asset Value (value of component stocks).

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  • Raysor
    Lv 7
    9 years ago

    An ETF turns any instrument into a security (share). The S&P500 is an index. You 'buy' an index via the Future or option or by buying all the index constituents. The ETF, therefore, must move up and down virtually identically to the underlying.

    As an example let's take a physical gold ETF. The ETF provider buys a load of gold, puts it into a vault and issues ETF certificates to he same value. Those certificates (shares) are bought in the market. If the value of the gold in the vault goes up the ETFs go up the same percentage.

    You should note thatthe price of the ETF is not necessarily the same price as its underlying. If I start a gold ETF today I could say they are $21 relative to the physical being $1800. If gold goes up 10% to $1980 my ETF will go up 10% to $23. There will be a tiny element of supply and demand in the ETF but it will track its underlying quite closely. After all the ETF is the underlying but in a different form.

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  • 9 years ago

    Because there are people who want the money that they gain by selling it. When a stock.ETF or the index goes high/rallies, it can only go so high and at a point it will not be anymore valuable than it's highest value. Traders want to sell right before that point because when it get too high, it is considered over rated. It then will go back down some to reflect it's reality value. Traders want to sell between the reality value and over rated value or sell at the highest point. Since no one actually knows this point, selling during the rally is the best chance of making a profit on that ETF. The last thing a trader wants is to sell at the lowest price. There is a saying in the stock market that Pigs always get slaughtered. It means that the greedy trader who doesn't sell because the stock is rallying, lost because they wanted the rally so much they wouldn't depart from the stock. It's like a gambler who wouldn't leave the table with winnings, thinking they are going to win win and win. Then they lost all their chips and now they leave empty handed or slaughtered..

    Source(s): You got to know when to hold 'em, know when to fold 'em, Know when to walk away and know when to run.
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  • Nancy
    Lv 4
    4 years ago

    Ask Poser Mobile they might know

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