6

A mutual fund is just a portfolio of stocks (or other assets) and hence the fund performs as well as its holdings [minus various fees]. However, an exchange traded fund (ETF) performs, like a stock, based on trades. I assume that means if everyone started selling an ETF at the same time, even if the stock prices for the positions in that ETF were increasing, the price of the ETF would plummet. In theory, can an ETF decline while its investments are doing very well? If not, what prevents this from happening?

Here is a silly toy example. Say an ETF currently owns one share each of stock 1 worth $20 and stock 2 worth $30. And lets say the ETF is made up of two shares that are each worth $25.

What happens if the owners of each of those $25 shares wants to sell them and is willing to take a price of $1 per share if need be, regardless of the fact that the holdings of the ETF are far more valuable.

And let's say in addition, the max a buyer is willing to pay is also $1.
What happens?
Are ETFs not like stocks?
Would the price of this hypothetical ETF not plummet to $1?

3

The Creation/Redemption mechanism is how shares of an ETF are created or redeemed as needed and thus is where there can be differences in what the value of the holdings can be versus the trading price. If the ETF is thinly traded, then the difference could be big as more volume would be where the mechanism could kick in as generally there are blocks required so the mechanism usually created or redeemed in lots of 50,000 shares I believe. From the link where AP=Authorized Participant:

With ETFs, APs do most of the buying and selling. When APs sense demand for additional shares of an ETF—which manifests itself when the ETF share price trades at a premium to its NAV—they go into the market and create new shares. When the APs sense demand from investors looking to redeem—which manifests itself when the ETF share price trades at a discount—they process redemptions.


So, suppose the NAV of the ETF is $20/share and the trading price is $30/share. The AP can buy the underlying securities for $20/share in a bulk order that equates to 50,000 shares of the ETF and exchange the underlying shares for new shares in the ETF. Then the AP can turn around and sell those new ETF shares for $30/share and pocket the gain. If you switch the prices around, the AP would then take the ETF shares and exchange them for the underlying securities in the same way and make a profit on the difference.

SEC also notes this same process.

  • 1
    To clarify -- the Authorized Participant captures the spread between the value of the ETF components (typically, the stocks that make up the index that the ETF tracks) and the ETF itself. The 50,000-share threshold is there because it simplifies operations and shouldn't matter in highly liquid stocks. And a caution -- "ETNs" (exchange-traded notes) are often grouped in with ETFs but they are not the same. In an ETN you are trading directly with the note sponsor and relying on the sponsor's promise to track the associated index; there's no in-built arbitrage to limit tracking error. – Tom Hughes Nov 21 '16 at 17:15
  • I'm not sure I follow this answer could you perhaps work through an example, like the modified question? – WetlabStudent Nov 23 '16 at 4:55

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