Understanding how an ETF works

Question

I am trying to fully understand how an ETF works. For the sake of simplicity, let us restrict ourselves to physical replica ETFs.

Let us suppose that an ETF follows an index which tracks three stocks: Alice Enterprises (A), Bob Industries (B) and Charlie's (C).

We want to invest 1000$. The prices of each individual stock are 100$ (A) , 10$ (B) and 1$ (C) and the index weights at this moment are 60% (A), 30% (B), 10% (C).

If I am not mistaken, when we buy a fund tracking this same index the fund manager will automatically buy 600$ of A, 300$ of B and 100$ of C.

Now, if we buy an ETF the underlying process is unclear to me. I understand the concepts of authorised participant and NAV spread. If A increases its value to 110$, authorised shareholders will first ask the ETF their shares of A and sell them, and then they will buy the ETF, pushing its price upwards. This way the ETF price is automatically regulated and the authorised shareholders earn a profit. Everybody is happy.

In contrast to a fund, when we buy an ETF we are not generally buying it to the ETF manager. Instead, we are buying it to another investor. Therefore... As I understand it, no new shares are really bought. And thus, following the process above, if we buy the ETF we push its price upwards. This again creates a "gap", this time the price of the ETF is momentarily higher than its underlying assets and, therefore, authorised shareholders will sell ETF shares and buy shares of A, B and C.

So... An ETF manager only buys a fixed amount of shares when the ETF is created?

I want to know if I am correct in this reasoning about how the basics of physical ETFs work. I have tried to keep things as simple as possible. I understand that there will be lots of quirks and quincks, and it is great if these are elaborated in the answers.

Answer 1

The prices of each individual stock are 100$ (A), 10$ (B) and 1$ (C) and the index weights at this moment are 60% (A), 30% (B), 10% (C).

In other words, for every 6 shares of A (initially worth $600), the fund will hold 30 shares of B (worth $300), and 100 shares of C (worth $100). In other words, the initial ratio of shares A:B:C is 6:30:100.

In the following discussion, the initial net asset value (NAV) of 1 ETF share is $100, representing the value of 0.6 shares of A, 3 shares of B, and 10 shares of C.

If A increases its value to 110$ [...]

For every 6 shares of A (now worth $660), the fund will still be holding 30 shares of B (worth $300), and 100 shares of C (worth $100). As you can see, the value of the holdings has deviated from 60%, 30%, 10%. Indexes usually rebalance periodically (e.g. every three months). The proportion of shares (currently 6:30:100) will only be adjusted at the end of the period during rebalancing.

The NAV of 1 ETF share is now $106 (0.6*110 + 3*10 + 10*1 = 106).

If A increases its value to 110$, authorised shareholders will first ask the ETF their shares of A and sell them [...]

No. The authorized participants cannot redeem only shares of A, because if they redeem only shares of A, the fund's ratio of 6:30:100 will be ruined. They must redeem in the correct ratio. For every 6 shares of A, they will also get 30 shares of B, and 100 shares of C. The 6:30:100 ratio is fixed until the next rebalancing.

Creation and redemption

Redemption: The authorized participants can exchange their ETF shares for the shares of the underlying companies (A, B, C). Under what conditions will the authorized participants want to exchange their ETF shares for shares in A, B, C? Answer: when the ETF shares are trading below the NAV. For example, if the ETF shares can be bought at $105 on the stock exchange, the authorized participant can buy 10 shares of the ETF (cost: $1050). The authorized participant can then exchange those 10 ETF shares for 6 shares of A, 30 shares of B, 100 shares of C (total worth: $1060 because the NAV for 1 ETF share is $106). Net profit: $1060-$1050 = $10. This is the redemption mechanism of ETFs. ETF shares are redeemed/destroyed in the process.

Creation: In the reverse situation (when the ETF shares are trading above NAV), the authorized participants will exchange shares in A, B, C (in the correct proportion of 6:30:100) for ETF shares. For example, if the ETF shares are trading at $109 on the stock exchange, an authorized participant can buy 6 shares of A, 30 shares of B, 100 shares of C on the market (cost: $1060). Then the authorized participant can exchange those shares for 10 ETF shares (worth: $1090). Net profit: $1090-$1060 = $30. When authorized participants exchange their shares of A, B, C for ETF shares, ETF shares are created.

So... An ETF manager only buys a fixed amount of shares when the ETF is created?

As you can see from the creation and redemption mechanism explained above, the ETF manager has no need to buy or sell shares in A, B, C (except when rebalancing). The ETF manager gets those shares from the authorized participants, and the authorized participants get new ETF shares in exchange.