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I'm having trouble wrapping my head around how it's possible to have these new active ETFs. How do they operate, realistically?

I mean, the point of ETFs (as a structure) is that arbitrageurs can wrap up $50K worth of an ETF's securities and exchange them for ETF shares, or vice versa, thus causing the price of the ETF to stick to the value of the index. (and making those arbitrageurs a nice safe little profit in the process)

So how on earth is that supposed to work when someone's changing what the ETF has in it all the time?

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  • Give an example of an ETF that you're referring to.
    – duffbeer703
    Commented Mar 4, 2012 at 2:11
  • @duffbeer703 Sure: Pimco's new Total return ETF. Articles discussing it are what sparked this thought. Apparently, it just started trading March 1st under the symbol TRXT
    – Patches
    Commented Mar 6, 2012 at 5:05

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An exchange-traded fund is just a fund that trades on an exchange. The "trading on an exchange" part does not really limit what they can do inside the fund, it just affects how share ownership happens.

The fact that most ETFs are index funds or similar vehicles is a matter of historical convention, not definition or law. The fact that funds may not be actively traded by arbitragers and that their price may deviate from the market value of their underlying assets is a real risk that will be discussed in the prospectus of any ETF.

If you can't work out the real value, then you can either take a risk or you can not trade the security. A retail investor who will buy and hold the ETF (i.e. not a day trader) might not worry about whether the price he gets is 5 minutes old or 20 minutes old, because his timeframe is substantially longer than any of that and volatility is a fact of life anyway.

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Why not? I mean, either way they wrap $50K worth of securities and exchange them for ETF shares. Then, if they sell $50K worth of securities and buy $50K worth of different securities, the overall ETF share price remains the same. If each $50K chunk goes 10% down at the end of the day, the ETF went 10% down. The fact that it was because various sell/buy/sell/buy sequences and not because the underlying securities went down doesn't matter much (well, there's additional expense on fees and taxes which will bring the ETF shares down overtime).

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  • I'm not sure I follow what you're saying. If a S&P500 ETF outpaces the index, then someone can buy stocks in the S&P in the right proportions, exchange them with the ETF company for new ETF shares, and sell those on the market. They earn the difference, and their selling makes the ETF move toward where the index is. But how do you do that when there's no index?
    – Patches
    Commented Mar 3, 2012 at 5:20
  • @Patches - exactly the same. Its just that active ETF's don't have to keep the index proportions.
    – littleadv
    Commented Mar 3, 2012 at 5:23
  • I guess maybe this is one of those things that's so simple its easy to miss? I've done more googling since, and I see what you mean, at least in your response to my comment. I suppose if they report daily, or perhaps even real time, there shouldn't be any reason why the proper arbitrage couldn't happen. Still, it seems weird to me. We'll see how it works out, especially with the new Pimco ETF. I hope it does: the tax treatment of ETFs is perfectly logical; of regular mutual funds, perfectly bone headed.
    – Patches
    Commented Mar 6, 2012 at 5:15

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