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From my understanding an ETF has the advantages of a managed fund with the advantages of a stock.

Advantages of a managed fund:

a) An ETF is a collection of stocks that are packaged into a single purchasable unit.

b) The ETF is managed to some degree, and money will be allocated to stocks which fit the criteria of the ETF (e.g high growth, international, industry)

Advantages of a Stock:

a) Each unit of the ETF is tradeable, and can be bought/sold on the stock market.

b) Low management fees compared to a full scale managed fund

This being the case, what actually determines the price of an ETF and what causes the price of an ETF to increase/decrease?

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Like most other things in economics, the price of an ETF is determined via supply and demand.

The important thing that's unique to ETFs is that there's a fairly efficient, nearly unlimited supply and demand at the "net asset value" (NAV), because "authorized participants" (typically large financial firms) can swap a group of ETF shares for a basket of the underlying equities (in either direction), any time the price difference makes it worthwhile. The ETF share itself is basically just an IOU for a fraction of one of the baskets of components, and the ETF sponsor holds the underlying shares (possibly lending them for an additional profit, which would offset management fees and/or be paid out as a dividend alongside the dividends of the components)

So the ETF price will always track close to the NAV. There will be a small premium or discount depending mainly on the "fear factor" associated with the ETF and its component equities. But the arbitrage opportunity keeps the premium or discount from becoming larger than the execution cost of swapping baskets.

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  • So what your saying is, whilst the price of the ETF is dictated by market forces, it will be closely aligned with the actual NAV, because large finance forms are swapping massive amounts of units
    – Darren rogers
    Jan 14, 2019 at 5:52
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    @Darrenrogers: Because of the possibility to convert between ETF shares and basket of components, the market forces on the ETF leak also act onto the component stocks (or bonds, or whatever) and the market forces on the components also act on the ETF.
    – Ben Voigt
    Jan 14, 2019 at 5:55

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