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My understanding of ETF is that they contain a basket of various stocks, and they usually track pretty closely to an index. So their share price depends on how well the basket of stocks are doing.

In this case, does it mean that the share price of ETF will always be tracking the index and will be unaffected by the volume of people selling and buying that ETF? In other words, if there is a huge volume of people buying an ETF, it will not jack up its share price as price is based on the stocks the fund consists of?

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The price of an ETF is not automatically linked to the price of the underlying stocks, so it is possible for it to get slightly out of step depending on supply and demand.

However, every ETF has a set Authorized Participants associated with the ETF. At any time, they are entitled to either deliver the underlying stocks that make up the ETF to the ETF manager and receive units of the ETF in exchange, or vice-versa: exchange units of the ETF for the underlying stocks.

So suppose the "bid" price of the ETF rises above the "ask" price of the underlying stocks. An authorized participant can buy the stocks, deliver them to the ETF manager in exchange for units of the ETF, and sell those on the market for a profit. As long as the difference in prices is enough to cover any transaction costs, they have an incentive to do it. And the effect will be to increase supply of the ETF and increase demand for the underlying stocks: so all else being equal, the ETF price will drop and the underlying shares price will rise, reducing the discrepancy. The same effect applies in the opposite direction if the price of the ETF drops too far.

So the prices won't drift very far apart - roughly speaking, the price of the ETF will need to stay within the bid/ask spread of the underlying stocks. If the underlying stocks are illiquid that could be quite a wide window, but that's to be expected.

Note that depending on the sizes of the respective markets, the correction might be either to the price of the ETF, or to the price of the underlying stocks, or to both.

  • AP intervention is not going to be very effective if the underlying assets have poor liquidity. – xiaomy Jun 18 '17 at 16:59
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    @xiaomy I edited to talk about the spread in the underlying stocks. – GS - Apologise to Monica Jun 20 '17 at 22:28
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ETF is that they contain a basket of various stocks, and they usually track pretty closely to an index. So their share price depends on how well the basket of stocks are doing.

Yes this is right.

does it mean that the share price of ETF will always be tracking the index and will be unaffected by the volume of people selling and buying that ETF?

The price will change depending on the demand and supply. The closing value of ETF on an exchange may be different than the NAV of the underlying shares, however this is generally not very way off.

The fund manager creates a specific number of units of ETF and whatever trading is happening is on these. So lets say the underlying value of assets is 100 [as well as the index]. Now during the day, if the value of assets falls off to say 98; the ETF may even get sold at 96 or 97 as quite a few people want to sell of the investments. Like wise it may rise more than the actual appreciation.

If the price movements are beyond normal thresholds, the fund manager Authorized participants would step in to stabilize the price by taking corrective buy / sell actions.

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    ETFs use "Authorized Participants" to handle the corrective buy/sell actions, not the fund manager. Also, lots of buying/selling of the ETF will lead to lots of buying/selling of the underlying stocks which might move their prices. Either way, the prices should stay in step, but if there's sufficient volume it could be that the stocks will move to follow the ETF and not vice-versa. – GS - Apologise to Monica Jun 16 '17 at 10:10

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