Must ETF companies match an investor's amount invested in an ETF?

Question

_{¹Source: p 147, Investing For Canadians For Dummies, 3 Ed (2009) by Tony Martin, Eric Tyson}

_{The lack of CDIC insurance on a money market fund shouldn’t trouble you. Mutual fund companies can’t fail because they have a dollar invested in securities for every dollar that you deposit in their money funds. By contrast, banks are required to have available just a fraction of every dollar that you hand over to them.}

_{A money market fund’s investments can decline slightly in value, which can cause the money market fund’s share price to fall below a dollar. In a few cases, money market funds have bought some bad investments. However, in each and every case except one, the parent company running the money market fund infused cash into the affected fund, thus enabling it to maintain the $1-per-share price.}

Does the bolded sentence apply for ETFs and ETF companies? To wit, must ETF companies invest a dollar in the ETF for every dollar that an investor deposited in this aforesaid ETF?

I know that mutual funds and ETFs differ. For instance, mutual funds can only be traded daily, but ETFs trade like stocks on a stock exchange. Nonetheless, I still wish elucidation on this question.

Answer 1

First, it's an exaggeration to say "every" dollar. Traditional mutual funds, including money-market funds, keep a small fraction of their assets in cash for day-to-day transactions, maybe 1%. If you invest $1, they put that in the cash bucket and issue you a share. If you and 999 other people invest $100 each, not offset by people redeeming, they take the aggregated $100,000 and buy a bond or two. Conversely, if you redeem one share it comes out of cash, but if lots of people redeem they sell some bond(s) to cover those redemptions -- which works as long as the bond(s) can in fact be sold for close enough to their recorded value.

And this doesn't mean they "can't fail". Even though they are (almost totally) invested in securities that are thought to be among the safest and most liquid available, in sufficiently extreme circumstances those investments can fall in market value, or they can become illiquid and unavailable to cover "withdrawals" (redemptions).

ETFs are also fully invested, but the process is less direct. You don't just send money to the fund company. Instead:

• a large "market maker" buys (from the market) a "basket" of securities matching the specified portfolio of the fund, trades that basket to the fund company for a large block of shares, and then sells those shares on the market
• when you buy shares, you buy them on the market from whoever who is selling, either a market maker or another person (or several) who previously bought and now wants to sell
• the price you buy at is not computed from the underlying securities, as a traditional fund's NAV is. But if the market price for shares goes much above NAV, a market maker can make a profit by creating a new block and selling them -- and it does, which pushes the share price back down.
• similarly when you sell ETF shares, you don't get cash from the fund. Instead you sell on the market, to anyone who wants to buy. And if that market price goes much below NAV, a market maker can make a profit by buying a block of shares and redeeming them for the underlying securities, pushing the share price back up.
• Depending on the broker and possibly account you use, you may pay a commission on ETF trades (both buy and sell). Money-market traditional funds don't have loads or transaction restrictions, although they appear to generally have slightly higher management fees, with about the same impact on your return as typical commissions.

Thus as long as the underlyings for your ETF hold their value, which for a money market they are designed to, and the markets are open and the market maker firms are operating, your ETF shares are well backed. See https://en.wikipedia.org/wiki/Exchange-traded_fund for more.

Answer 2

Does the bolded sentence apply for ETFs and ETF companies?

No, the value of an ETF is determined by an exchange and thus the value of the share is whatever the trading price is. Thus, the price of an ETF may go up or down just like other securities. Money market funds can be a bit different as the mutual fund company will typically step in to avoid "Breaking the Buck" that could happen as a failure for that kind of fund.

To wit, must ETF companies invest a dollar in the ETF for every dollar that an investor deposited in this aforesaid ETF?

No, because an ETF is traded as shares on the market, unless you are using the creation/redemption mechanism for the ETF, you are buying and selling shares like most retail investors I'd suspect. If you are using the creation/redemption system then there are baskets of other securities that are being swapped either for shares in the ETF or from shares in the ETF.

Answer 3

The point here is actually about banks, or is in reference to banks. They expect you know how a savings account at a bank works, but not mutual funds, and so are trying to dispel an erroneous notion that you might have -- that the CBIC will insure your investment in the fund.

Banks work by taking in deposits and lending that money out via mortgages. The mortgages can last up to 30 years, but the deposits are "on demand". Which means you can pull your money out at any time.

See the problem? They're maintaining a fiction that that money is there, safe and sound in the bank vault, ready to be returned whenever you want it, when in fact it's been loaned out. And can't be called back quickly, either. They know only a little bit of that money will be "demanded" by depositors at any given time, so they keep a percentage called a "reserve" to satisfy that, er, demand. The rest, again, is loaned out. Gone.

And usually that works out just fine. Except sometimes it doesn't, when people get scared they might not get their money back, and they all go to the bank at the same time to demand their on-demand deposits back. This is called a "run on the bank", and when that happens, the bank "fails". 'Cause it ain't got the money.

What's failing, in fact, is the fiction that your money is there whenever you want it. And that's really bad, because when that happens to you at your bank, your friends the customers of other banks start worrying about their money, and run on their banks, which fail, which cause more people to worry and try to get their cash out, lather, rinse repeat, until the whole economy crashes. See -- The Great Depression.

So, various governments introduced "Deposit Insurance", where the government will step in with the cash, so when you panic and pull all your money out of the bank, you can go home happy, cash in hand, and don't freak all your friends out. Therefore, the fear that your money might not really be there is assuaged, and it doesn't spread like a mental contagion. Everyone can comfortably go back to believing the fiction, and the economy goes back to merrily chugging along.

Meanwhile, with mutual funds & ETFs, everyone understands the money you put in them is invested and not sitting in a gigantic vault, and so there's no need for government insurance to maintain the fiction.

And that's the point they're trying to make. Poorly, I might add, where their wording is concerned.