Help me understand this ETF thing...

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chrismckay
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Help me understand this ETF thing...

Post by chrismckay »

Trying to understand the workings of an ETF and some pieces puzzle me.

I understand that the ETF trades in real time and can be bought/sold at anytime during market hours, happy with that.

However, if an ETF trades on the open market isn't it at the mercy of price fluctuations independent of the underlying assets?. For instance take a hypothetical situation and fund, Fidelity UK ETF, the ETF mirrors the UK market closely, however Fidelity has had some adverse publicity with possible risk of going out of buisness.

This scenario causes investors to sell their holding in Fidelity UK ETF......so, does the fund price change from the index it is tracking?

Chris.... :happy
finrod_2002
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Re: Help me understand this ETF thing...

Post by finrod_2002 »

There are plenty of threads here that discuss this, I cannot find any links at this moment myself. Also there should be a Vanguard article explaining this in great detail.

I try to give you a short, basic answer from my own understanding.
Basically new ETF shares can be created or removed every day based on the NAV (net asset value). The net asset value is the value of the underlying assets. Based on that if the current ETF price is above that price, new ETF shares will be created and so the ETF price eventually will decrease until it gets close to the NAV. If the current price is lower than the NAV ETF shares are removed/deleted (I think technically they call it redeemed). So less shares, price per share increasing till again it gets close to the NAV.

Probably not completely technically correct, but that is the whole wizardry. :sharebeer
TedSwippet
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Re: Help me understand this ETF thing...

Post by TedSwippet »

What finrod_2002 said above. Here's a little more added detail.
chrismckay wrote: Thu Feb 20, 2020 2:16 am However, if an ETF trades on the open market isn't it at the mercy of price fluctuations independent of the underlying assets?. For instance take a hypothetical situation and fund, Fidelity UK ETF, the ETF mirrors the UK market closely, however Fidelity has had some adverse publicity with possible risk of going out of buisness. This scenario causes investors to sell their holding in Fidelity UK ETF......so, does the fund price change from the index it is tracking?
There are multiple levels of corporate ownership. For example, Fidelity UCITS ICAV is legally separate and distinct from Fidelity itself, and is a corporation set up specifically to hold ETF assets under management and nothing else:
FIDELITY UCITS ICAV
An Irish collective asset-management vehicle constituted as an umbrella fund with segregated liability between Sub-Funds with registration number C158668 and authorised by the Central Bank of Ireland pursuant to the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations 2011, as amended
Within this, each Fidelity ETF is segregated from the others:
Fidelity UCITS ICAV is established with segregated liability between sub-funds which means that the assets and liabilities of each subfund are segregated by law so that investors have no claims over the assets of a sub-fund in which they do not own shares.
So the fund is a separate corporation whose only assets are the stocks or whatever under management that it holds. If the company managing the assets gets into trouble, the assets themselves should be unaffected. (Well, barring actual fraud, in practice hard to achieve due to oversight from several other parties.)

That's not to say that if Fidelity wobbled, some investors might sell Fidelity ETFs anyway, and perhaps affect the ETF's price. ETFs can sometimes trade at moderate discounts or premiums to NAV, but their open-ended structure and the way units are created and destroyed makes this far less prevalent than can occur with investment trusts. And with synthetic ETFs in particular, there's the potential for counterparty issues to affect the ETF price (personally I like to stick with physical replication structures, which is in practice most of them, but that might just be me).
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nisiprius
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Re: Help me understand this ETF thing...

Post by nisiprius »

You are correct that the ETF is "at the mercy of price fluctuations independent of the underlying assets" but it is not a serious matter. It is usually close to negligible. (There are endless debates about whether mutual funds or ETFs are better. In my opinion this does put a featherweight on the mutual fund side of the scales, but there are additional feathers on each side).

You can judge the size of the problem by going to the factsheets and such for an ETF you are curious about and comparing, say, the total annual return based on NAV to the return based on market price. I don't know how to do this through British eyes... hmmm... maybe it's not as easy to find NAV-versus-market-returns for British ETFs... let's take a Vanguard US ETF. To make it realistic I will choose one that is not among the very biggest or most heavily traded: Vanguard S&P Small-Cap 600 Growth ETF (VIOG), which has $387 million in assets. (When ETFs get below $50 million in assets they at risk of being discontinued).

VIOG performance

Image

The "NAV" returns are what you "should" have gotten, based on the market values of the stocks within the ETF. The "market price" returns are what you would have actually gotten, buying and selling in the market. The difference is due to the effect of "price fluctuations independent of the underlying assets."

Let's say I have package of stocks. Logically, if I have a package of two stocks, A and B, and my holdings of these stocks have market values of £50 and £100, and say I will only trade them as a package. I want to sell that package. Imagine a willing buyer who is convinced that there's no fraud--the package really contains those stocks--and who is able to open the package and break out the stocks after buying them. Most of the time, you would expect to find a buyer willing to pay close to £150 for the package. How close? If the buyer is sure they can turn around and sell the stocks before the prices change much, even a tiny discount--£149, £149.50, £149.97--is enough to motivate the sale since the buyer is sure making an almost-certain profit.

Given a liquid market, reliable market prices, and the ability to break up an ETF, there's no logical reason why the act of packaging stocks together would make them worth much more or much less than the sum of their individual values.

So, let's make the picture slightly more realistic. Two more details. 1) ETF goes out of business. 2) ETF provider goes out of business. 3) Price of ETF deviates from NAV (sum of market prices of its holdings).

1) What if an ETF, goes out of business? Well, this isn't like an airline seat or a health club membership, where you are paying today for a promise to do something months later. The stocks actually exist, the regulations behind ETFs give a high degree of assurance that it is so. If you own the ETF, you have a claim on stocks that actually exist. If the ETF folds, the ETF is liquidated--broken into its separate stocks, the stocks are sold, and the proceeds given to the ETF shareowners. Because of time delays in the process, there could be inconvenience or differences in what you get from the last market price.

2) This is more complicated and I don't know the details even for the US, but, again, the assets are really there, and if a brokerage fails you are going to get the assets you own one way or another--most likely by having another brokerage take over customers' accounts.

3) In reality, ordinary investors do not have the option of breaking up the ETF and selling the stocks it holds. However, there are investors who do, investors with a special status, the "authorized participants." They do buy and sell the stocks in the ETF, and it is actually their job to make market transactions that keep the market price of the ETF close to the NAV (total of the market values of the stocks in the ETF). If nobody actually wants to buy the stocks in the ETF as a package, perhaps because there is market turmoil and they are short of cash, then market price of the ETF will fall below the NAV. When this happens, the authorized participants step in and buy the ETF, making the price rise. They can turn around and break up the ETF into stocks and sell the stocks. If the ETF is selling below NAV, they have an opportunity for a quick profit with almost no risk, so they have a motivation to do this.

Yes, on occasion, the market price of an ETF can deviate from the NAV. But for a "normal" biggish ETF, a deviation of as much as 1% is considered extraordinary. It does happen, though, and for a real-life example read Rick Ferri's posting on Solving the Bond ETF Discount Problem.
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Jack FFR1846
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Re: Help me understand this ETF thing...

Post by Jack FFR1846 »

Both mutual funds and ETFs are at the same risk of their values dropping regardless of what the underlying stocks do. Say everyone owns the ETF and hears that all the ETF underlying companies have been wiped out by a hurricane on Fake News and puts in sell orders. The price drops. Say instead, the rumors persist for days and mutual fund owners put in the same sell orders. Well, the NAV drops at the end of the day, just like the ETFs did.

Both are pretty unlikely. I look at the 2 as beer containers. Mutual funds are aluminum cans and ETFs are aluminum bottles. The beer's the same.
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senex
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Re: Help me understand this ETF thing...

Post by senex »

Jack FFR1846 wrote: Thu Feb 20, 2020 11:01 am Both mutual funds and ETFs are at the same risk of their values dropping regardless of what the underlying stocks do.
Both risks are low but are not the same.
A retail MF investor can redeem at nav.
A retail ETF investor can only sell at the market price, which can in theory (though rare in practice) be persistently below nav.

Both have similar risks related to underlier liquidity, but ETFs have additional price and liquidity risks related to technical or business problems of the Authorized Participants.
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chrismckay
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Re: Help me understand this ETF thing...

Post by chrismckay »

I want to thank all who replied to this post,

The level of information and the time taken to post replies has been amazing.

thanks
Chris... :happy
Last edited by chrismckay on Fri Feb 21, 2020 3:29 am, edited 1 time in total.
02nz
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Re: Help me understand this ETF thing...

Post by 02nz »

finrod_2002 wrote: Thu Feb 20, 2020 3:51 am There are plenty of threads here that discuss this, I cannot find any links at this moment myself. Also there should be a Vanguard article explaining this in great detail.

I try to give you a short, basic answer from my own understanding.
Basically new ETF shares can be created or removed every day based on the NAV (net asset value). The net asset value is the value of the underlying assets. Based on that if the current ETF price is above that price, new ETF shares will be created and so the ETF price eventually will decrease until it gets close to the NAV. If the current price is lower than the NAV ETF shares are removed/deleted (I think technically they call it redeemed). So less shares, price per share increasing till again it gets close to the NAV.

Probably not completely technically correct, but that is the whole wizardry. :sharebeer
I don't believe this is correct. ETFs can trade at a discount to or premium over NAV. But it's the market that keeps that amount relatively small in most cases (because of arbitrage - i.e., traders taking advantage until the difference is 0). Shares are not somehow "created" or "deleted" to bring the price closer to NAV, as far as I understand.
andrew99999
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Re: Help me understand this ETF thing...

Post by andrew99999 »

02nz wrote: Fri Feb 21, 2020 1:37 am Shares [in ETFs] are not somehow "created" or "deleted" to bring the price closer to NAV, as far as I understand.
Yes they are. Bloomberg had a great article explaining it.
https://www.bloomberg.com/features/2016-etf-files/toy/.
senex
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Re: Help me understand this ETF thing...

Post by senex »

02nz wrote: Fri Feb 21, 2020 1:37 am I don't believe this is correct. ETFs can trade at a discount to or premium over NAV. But it's the market that keeps that amount relatively small in most cases (because of arbitrage - i.e., traders taking advantage until the difference is 0). Shares are not somehow "created" or "deleted" to bring the price closer to NAV, as far as I understand.
You're both somewhat right, but missing some detail.

The create/redeem process does occur, and it *is* a critical piece of the mechanism that keeps trading price close to nav. (It is part of the arbitrage you mention).

However, the process only occurs at the end of each day (not intraday), and is only exercised by "Authorized Participants," which are large firms that have gone through an approval process. It does not occur intraday nor is it decided directly by the etf company itself.
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jhfenton
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Re: Help me understand this ETF thing...

Post by jhfenton »

senex wrote: Fri Feb 21, 2020 11:18 am You're both somewhat right, but missing some detail.

The create/redeem process does occur, and it *is* a critical piece of the mechanism that keeps trading price close to nav. (It is part of the arbitrage you mention).

However, the process only occurs at the end of each day (not intraday), and is only exercised by "Authorized Participants," which are large firms that have gone through an approval process. It does not occur intraday nor is it decided directly by the etf company itself.
Intraday, however, they can sell ETF shares short and hedge that exposure by buying the basket of securities. The effect is essentially the same as creating the shares intraday, even if the actual creation occurs at end of day.
senex
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Re: Help me understand this ETF thing...

Post by senex »

jhfenton wrote: Fri Feb 21, 2020 3:40 pm Intraday, however, they can sell ETF shares short and hedge that exposure by buying the basket of securities. The effect is essentially the same as creating the shares intraday, even if the actual creation occurs at end of day.
Yep, when things work smoothly, this is correct. And things almost always work smoothly.

When the APs have problems (technical or financial), that arbitrage process can break down, leading to wider spreads or intraday dislocations from NAV. This is the type of risk I mentioned in my first post that is particular to ETFs (compared to mutual funds).
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Re: Help me understand this ETF thing...

Post by Starfox »

Is there a pro/con to ETF vs fund, if the expense ratio is the same?

I know one Pro is if I have ETF, I can easily move my assets to Fidelity, etc, and continue as usual with buy/sell/reinvest, compared to funds.

Is there anything else on the pro/con? All my equity stock assets Total Stock/Bond variety (US/INTL), and are in Vanguard Brokerage, and the expense ratios are the same as ETF. One asset (VWIUX) I would have to exchange for VTEB, because there is not an identical ETF.

Am I missing anything on the pro/con list?
Texanbybirth
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Re: Help me understand this ETF thing...

Post by Texanbybirth »

nisiprius wrote: Thu Feb 20, 2020 10:53 am You are correct that the ETF is "at the mercy of price fluctuations independent of the underlying assets" but it is not a serious matter. It is usually close to negligible. (There are endless debates about whether mutual funds or ETFs are better. In my opinion this does put a featherweight on the mutual fund side of the scales, but there are additional feathers on each side).

You can judge the size of the problem by going to the factsheets and such for an ETF you are curious about and comparing, say, the total annual return based on NAV to the return based on market price. I don't know how to do this through British eyes... hmmm... maybe it's not as easy to find NAV-versus-market-returns for British ETFs... let's take a Vanguard US ETF. To make it realistic I will choose one that is not among the very biggest or most heavily traded: Vanguard S&P Small-Cap 600 Growth ETF (VIOG), which has $387 million in assets. (When ETFs get below $50 million in assets they at risk of being discontinued).

VIOG performance

Image

The "NAV" returns are what you "should" have gotten, based on the market values of the stocks within the ETF. The "market price" returns are what you would have actually gotten, buying and selling in the market. The difference is due to the effect of "price fluctuations independent of the underlying assets."

Let's say I have package of stocks. Logically, if I have a package of two stocks, A and B, and my holdings of these stocks have market values of £50 and £100, and say I will only trade them as a package. I want to sell that package. Imagine a willing buyer who is convinced that there's no fraud--the package really contains those stocks--and who is able to open the package and break out the stocks after buying them. Most of the time, you would expect to find a buyer willing to pay close to £150 for the package. How close? If the buyer is sure they can turn around and sell the stocks before the prices change much, even a tiny discount--£149, £149.50, £149.97--is enough to motivate the sale since the buyer is sure making an almost-certain profit.

Given a liquid market, reliable market prices, and the ability to break up an ETF, there's no logical reason why the act of packaging stocks together would make them worth much more or much less than the sum of their individual values.

So, let's make the picture slightly more realistic. Two more details. 1) ETF goes out of business. 2) ETF provider goes out of business. 3) Price of ETF deviates from NAV (sum of market prices of its holdings).

1) What if an ETF, goes out of business? Well, this isn't like an airline seat or a health club membership, where you are paying today for a promise to do something months later. The stocks actually exist, the regulations behind ETFs give a high degree of assurance that it is so. If you own the ETF, you have a claim on stocks that actually exist. If the ETF folds, the ETF is liquidated--broken into its separate stocks, the stocks are sold, and the proceeds given to the ETF shareowners. Because of time delays in the process, there could be inconvenience or differences in what you get from the last market price.

2) This is more complicated and I don't know the details even for the US, but, again, the assets are really there, and if a brokerage fails you are going to get the assets you own one way or another--most likely by having another brokerage take over customers' accounts.

3) In reality, ordinary investors do not have the option of breaking up the ETF and selling the stocks it holds. However, there are investors who do, investors with a special status, the "authorized participants." They do buy and sell the stocks in the ETF, and it is actually their job to make market transactions that keep the market price of the ETF close to the NAV (total of the market values of the stocks in the ETF). If nobody actually wants to buy the stocks in the ETF as a package, perhaps because there is market turmoil and they are short of cash, then market price of the ETF will fall below the NAV. When this happens, the authorized participants step in and buy the ETF, making the price rise. They can turn around and break up the ETF into stocks and sell the stocks. If the ETF is selling below NAV, they have an opportunity for a quick profit with almost no risk, so they have a motivation to do this.

Yes, on occasion, the market price of an ETF can deviate from the NAV. But for a "normal" biggish ETF, a deviation of as much as 1% is considered extraordinary. It does happen, though, and for a real-life example read Rick Ferri's posting on Solving the Bond ETF Discount Problem.
Thank you for this, very educational and helpful.
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