# Understanding how an ETF works

I am trying to fully understand how ETFs work. 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). 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 withdraw shares of A from the ETF and sell those shares, and then they will buy the ETF, pushing the ETF 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 ETF shares from the ETF manager. Instead, we are buying ETF shares from 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.

• Can you please edit this, as some of the language is unclear: I don't know what "authorised shareholders will first ask the ETF their shares of A and sell them" is meant to mean / "buying it to the ETF manager" do you mean from the ETF manager? Jul 14, 2020 at 0:32
• @curiousdannii it is unclear what you are asking.
– D1X
Jul 14, 2020 at 9:19
• I have made some edits to address the valid concerns from @curiousdannii. Please check that I have preserved the original intent of your question.
– Flux
Apr 6, 2021 at 21:23

The prices of each individual stock are 100\$ (A), 10\$ (B) and 1\$ (C). 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 withdraw shares of A from the ETF and sell those shares [...]

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.

• This is a good answer. I always wondered if massive ETFs like SPY do intraday trading, based on the massive inflows / outflows that can happen intraday. The typical answer is that “rebalancing is done on the closing auction”, but on high inflow/outflow days, it seems that rebalancing would have to be a continuous process. Jun 14, 2020 at 6:17
• How does creation/redemption work when the fund has 500 component stocks at arbitrary decimal ratios? Does it only happen at the lowest common denominator, so that for an ETF priced at \$100 the creation/redemption might need \$100K of component stock? Some ETFs have thousands of component stocks, how would anyone get the exact right ratio? Jul 14, 2020 at 0:39
• Also, what do you mean by "authorised participants"? Is it only big investors/market makers? Do the ETF managers charge a fee for creation/redemption, or is the cost of the exchanges part of the general annual fee? Jul 14, 2020 at 0:47
• @curiousdannii The answers to all your questions will vary by ETF. All your questions can be answered by reading the ETF prospectus. This is what the prospectus is for. The ETF prospectus will explain the details of the creation/redemption process, define "authorized participants", and state the fees.
– Flux
Jul 14, 2020 at 2:10
• @curiousdannii I will use SPY (SPDR S&P 500 ETF Trust) as an example. The ETF currently requires authorized participants to transact in multiples of 50,000 ETF units. At the current NAV of approximately US\$315, each creation/redemption transaction involves at least US\$15 million. The component stocks involved in creation/redemption is determined by the manager, and may not necessarily include all 500 component stocks. There is a fee for creation/redemption (currently US\$3,000). As usual, all these details are in the prospectus.
– Flux
Jul 14, 2020 at 2:27