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>WORKING OF EXCHANGE TRADED FUNDS
ETFs originate with a fund sponsor, which chooses the ETF’s target index, determines which securities will be included in the “basket” of securities, and decides how many ETF shares will be offered to investors. Say, for example, a fund sponsor wants to create an ETF that tracks the S&P 500 Index. Because of the expense involved in acquiring the basket of securities that represent the securities listed on the S&P 500—which can run into the millions of dollars—the fund sponsor typically contacts an institutional investor to obtain and deposit with the fund the basket of securities. In turn, the ETF issues to the institutional investor a “creation unit,” which typically represents between 50,000 and 100,000 ETF shares. (Note that, unlike shares in a traditional mutual fund that are purchased with cash, ETF sponsors require its investors to deposit securities with the fund.)
Each ETF share represents a stake in every company listed on the S&P 500 Index. The institutional investor that holds the creation unit (the “creation unit holder”) is then free to either keep the ETF shares or to sell all or part of them on the open market. ETF shares are listed on a number of stock exchanges (NYSE, NASDAQ, Amex, etc.) where investors can purchase them through a broker-dealer.
Like other exchange-listed securities, a retail investor who purchases an ETF can liquidate its investment by selling its ETF shares at the current price. By contrast, a creation unit is liquidated when an institutional investor returns to the ETF the specified number of shares in the creation unit; in return, the institutional investor receives a basket of securities reflecting the current composition of the ETF.
The basket of securities deposited by the institutional investor with the fund sponsor has been predetermined by the sponsor to track a particular index. When changes are made to the index (a stock is added to or dropped from the index), the fund sponsor notifies the creation unit holders that changes need to be made to the basket of securities originally deposited with the fund to ensure that the basket continues to track the composition of the index.
Dividend and Management Fees
Unless the underlying index is a total return index, ETFs pay dividends to investors on a regular basis. Dividends paid by the stocks held in the ETF are accrued and kept as cash until they are paid to the investor. The management fee is deducted from this cash on a daily basis. When the dividends of the underlying stocks are not sufficient to cover the management fee, a small portion of the underlying stocks in the ETF are liquidated to cover it.
ETFs Trade Close To NAV
The NAV (Net Asset Value) of the ETF, expressed on a per share basis, is the value of the underlying constituents of the benchmark held by the ETF, plus the accrued dividends less the accrued management fee. Although the price at which an ETF trades is subject to the same supply and demand dynamics of a normal share, the creation/redemption process described above ensures that the price trades very close to the NAV. Since ETF shares can be created or redeemed at the NAV, a material discrepancy between the trading price of the ETF and its NAV can be arbitraged away.
