...and there's a lot of disagreement about how ETFs influence the market price of the individual components.

1) An ETF is a bucket of investments, like a mutual fund. But unlike a mutual fund where a group of professional managers decide the composition of the fund, an ETF has a specific formula that's public information. Everyone knows the formula.

2) there's no initial offer since it's really just a portfolio.

3) when you go to fidelity/schwab/your broker and buy shares of an ETF, chances are of the quantities that you and I might transact, they've got what it takes in their inventory to allocate all of the components of that ETF to a symbol (the ETF symbol) and drop it in your account. But that's for the common ETF and for the quantities you and I are probably talking about for our purposes.

For less common, or for large quantities, you probably have to talk with the trading desk and the trading desk will have to go wholesale to a mega-bank (JPMorgan/BankofNewYork/Citi) for a price and ability to fill the order.

Example, if an advisor managing a couple hundred million bucks or more wants to put something obscure in the portfolio (let's say CU, the copper ETF) and wants to put say 20 million bucks into CU. That's about 50% of CU's daily volume so it's likely to move the market and would probably take at least most of the day to fill...all while the price is running away from him.

Instead, the advisor calls their broker trade desk and says "get me a buy price on 20 million of CU". Trade desk says "I'll get back to you" and they call JPMorgan (for example), one of the banks who has agreed with the issuers of CU to "block and break" their ETF. In this case, JPM will "block" up the components of CU according to the formula and give the trade desk a price based on the component prices...maybe a "good for 5 minutes" kind of price. Trade desk calls the advisor (or more likely just takes them off hold) and quotes the price. Advisors hits the order and it's done.

Market never seeks the volume so it doesn't have a supply/demand effect directly on the price of the ETF. Any supply/demand effect occurs at the component level as the bank manages their inventory. Advisor now distributes CU out to the various client accounts.

If the advisor is selling rather than buying...the same thing happens but the trade deck asks the bank for the price to "break" the ETF...that is the price for the bank to take that volume of the ETF into their inventory and break it down into components that they may (or may not) keep in their inventory.

I used to have a schematic of this somewhere and I'll see if I can find it but that's the gist of it.

Hopefully this helps vs. hurts.

Last edited Fri Nov 24, 2023, 07:26 PM - Edit history (1)

intermediaries in some complicated process who seek to keep the price of the ETF from being too far from the Net Asset Value (NAV).

There is a myth that all ETF's are index funds and all mutual funds are active. False. Many ETFs are actively managed and don't follow an index. Likewise there are tons of mutual funds that follow an index.

Actually all funds are managed, e.g. an index fund of whatever variety tries to match the index it is following with a weighted selection of shares of SOME of the different companies that make up the index, and this process is ongoing.

When I use the term "actively managed" in the above I mean where the fund manager does their own selection of stocks with the goal of beating some benchmark on a risk-adjusted basis.

Example of one of many Vanguard funds that have both an ETF version and a mutual fund version:

Vanguard S&P 500 index fund:
ETF version: VOO
Mutual fund version: VFIAX

From a regular investor's standpoint, one buys and ETF just like a stock: during a trading day. It's a market between buyers and sellers. Buying or selling an ETF is just like buying and selling shares of a stock.

Whereas for mutual funds, one puts a request to buy X number of shares or D dollars worth of shares, and the fund company figures out the NAV for that after the next close and that's the price you get. (If you place your order after the close, you'll get the NEXT DAY's closing NAV)

Personally I prefer mutual funds because I hate the bid-ask spread of ETFs and having to place limit orders on ETFs to be on the safe side from a surprise move during the trading day. And I don't like having the price being different from the NAV, its just extra volatility to me when the premium or discount changes from one to the other or in magnitude.

Mutual funds always settle at the NAV after the close of the day's trading.

Speaking of index funds: Mutual index funds are perhaps slightly more expensive (a higher Expense Ratio, or ER) or they are the same as the corresponding ETF index funds.

There's a tax concern with mutual funds that are held in taxable accounts (not a factor if it's in some kind of IRA or 401k) -- they distribute capital gains distributions when they sell shares to meet redemptions or to get their portfolio to be back in balance. These are taxable. You get these taxable distributions even if you didn't sell any shares.

ETFs rarely have capital gains distributions because when they "sell" shares through some kind of trading mechanism with their intermediaries, so they actually swap shares or something like that rather than selling shares. Usually.

The personal finance and investing group is another resource to check out (though there is unfortunately some bad information there too sometimes). There is a former professional broker hosting the group who probably knows all the correct minutiae about all of this.

https://www.democraticunderground.com/?com=forum&id=1121

This is all off the top of my head and there are things I don't understand very well about ETFs.

https://www.etf.com/etf-education-center/etf-basics/etfs-vs-closed-end-funds

What Is an ETF?

An ETF, which stands for “exchange-traded fund,” is an investment security that holds other investment assets, such as stocks or bonds. ETFs are pooled securities like mutual funds, but as the name suggests, ETFs trade similarly to stocks on an exchange. Most ETFs passively track a benchmark index, such as the S&P 500, while some are actively managed.
What Is a Closed End Fund?

Closed-end funds, or CEFs, are portfolios of securities that pay out dividends and capital gains distributions, but, unlike ETFs, they can’t create or redeem shares on a daily basis. Instead, CEFs come to market through an IPO with a fixed number of shares. Like ETFs, CEFs trade intraday on an exchange, which means CEFs may trade at premiums or discounts to their net asset value (NAV).

It’s important to note that a closed-end fund is not the same as a traditional mutual fund, which is a type of open-end fund. Most ETFs are structured as open-ended funds, but some may be structured as unit investment trusts (UITs). The main difference between open-end funds and closed-end funds is that an open-end fund can issue an unlimited number of new shares and is priced daily on its NAV, whereas closed-end funds issue only a fixed number of shares.
ETFs vs Closed-End Funds: Similarities and Differences

Comparing the similarities and differences between ETFs and closed-end funds is not the same comparison as ETFs vs mutual funds. ETFs and closed-end funds are similar in that they both trade intraday on an exchange. However, while many ETFs track the performance of an index of securities, closed-end funds are actively managed.

More at the link.

I'm not sure I entirely agree with this article. Seems to me some ETFs also post deviations from Net Asset Value, but it could be I'm the one wrong about it.

Last edited Fri Nov 24, 2023, 07:56 PM - Edit history (1)

"but it could be I'm the one wrong about it."

Actually I think you are right -- I'd go further: ALL ETF's prices deviate somewhat from the NAV except by coincidence when they happen to match.

ETF prices are determined by a bidding war between buyers and sellers, just like stocks. That price, which changes minute by minute, is almost always either higher than the NAV (known as selling at a premium) or lower than the NAV (known as selling at a discount).

Thanks for the excellent article.

I'd quibble with this one excerpt from the article:

This implies that those ETFs that are also open-ended funds are priced at their NAV. They do figure out the NAV, but that's rarely (only by coincidence) the price that it is bought or sold at. Again, it's the bidding war between buyers and sellers that determines the price. The NAV is a piece of data that knowledgeable buyers and sellers look at, but that's about its only role in determining the price.