>EXCHANGE TRADED FUNDS: How Do ETFs Generate Returns for Investors?

The price of an ETF share depends on the forces of supply and demand in the market and on the performance of the underlying index. Of course, the performance of the index is determined by the performance of each component stock.


In some ways, holding a share in an ETF is like holding a share of any company’s stock. If an investor buys a share of XYZ Company’s stock for $10 on Monday and sells when the share price rises to $20 on Wednesday, he or she has made a $10 profit. But if that investor sells on
Friday, when the price of the stock has fallen to $8, he or she will experience a $2 loss. The same holds true for ETFs.


Pricing, however, differs between mutual funds and ETFs. For a mutual fund, the price at which investors buy and sell shares is equal to the fund’s net asset value (NAV), less any commissions. The NAVs of both mutual funds and ETFs are calculated daily at the close of the markets. While investors can buy and sell mutual fund shares are any time throughout the day, all investors will receive the same transaction price (the NAV). In contrast, the price of an ETF share is continuously determined on a stock exchange. Consequently, the price at which investors buy and sell ETF shares may not necessarily equal the NAV of the portfolio of securities in the ETF. In addition, two investors selling the same ETF shares at different times on the same day may receive different prices for their shares, both of which may differ from the ETF’s new asset value. The price of an ETF share on a stock exchange is influenced by the forces of supply and demand.


For example, when investor demand for an ETF increases, the ETF’s share price will rise, perhaps exceeding the ETF’s net asset value. ETFs are structured, however, so that large differences between their share prices and their NAVs are unlikely to persist. Third parties calculate and disseminate every 15 seconds a measure often called the Interday Indicative Value (IIV), which is a real-time estimate of a fund’s NAV. When an ETF’s share price is substantially above this indicative value, institutional investors may find it profitable to deliver the appropriate basket of securities to the ETF in exchange for ETF shares. Retail investors may find it profitable to take a short position in the ETF’s shares. When an ETF’s share price is substantially below its indicative value, institutional investors may find it profitable to return ETF shares to the fund in exchange for the ETF’s basket of securities. Retail investors may find it
profitable to take a long position in the ETF’s shares. These actions by investors help keep the market-determined price of an ETF’s shares close to the NAV of its underlying portfolio.


RISH TRADER