ETF Mechanics 101: A thread (1/x)

Exchange-traded funds are one of the most consequential developments in financial markets over the last three decades, but how exactly do they work?

How did aggregation become the name of the game in asset management instead of alpha?

First, a definition:

An ETF is an open-ended mutual fund that is listed on a public exchange with a predefined investment goal, such as tracking the NASDAQ 100 index or selecting the best semiconductor stocks.

Many types of ETFs and ETNs exist, but lets stick to equity funds.

What is an open end mutual fund you may ask?

An open ended fund is a pooled investment vehicle that has a mechanism for allowing investors to freely move in and out of their positions in the fund with some restrictions.

Closed end funds on the other hand, have limited supply.

Think of a pooled investment vehicle as it's own independent company, because legally it is

The only business that this company operates is trading securities that are outlined in its prospectus and investment mandate

Like any company - public or private - it has its own shares

These shares should add up to be equal to the total value of the underlying investments that the fund owns - the net asset value or NAV.

NAV calculations differ depending on the structure of the fund and can get quite complicated so lets stick to long-only equity funds.

An example:

If fund $ETF is intended to trade large cap tech stocks and owns 10 shares of $AMZN at $2500, 100 shares of $MSFT at $200 and 100 shares of $AAPL at $300, the NAV of the fund is $75,000 or ((2500*100)+(200*100)+(300*100))... assuming the fund has no liabilities.

Now take that NAV of $75,000 and imagine that there were 1,000 shares of $ETF trading on the secondary market... of course for $75.00 each.

Each share of $ETF is essentially made up of .33 shares of $AMZN, .26 shares of $MSFT, and .4 shares of $AAPL. This is the funds weighting

There are many ways to weight funds, the most popular of course being market-cap weighting because that's how the S&P500 and NAS100 are compiled.

Market cap weighting is a very simple but incredibly important concept because a few stocks move what people see as "the market."

As of market close on 6/17, a simple market cap weighted version of $ETF would look something like this:

$AMZN: $1.32t
+ $MSFT: $1.49t
+ $AAPL: $1.53t
= $4.43t total

$AMZN: 1.32/4.43 = .30
$MSFT: 1.49/4.43 = .33
$AAPL: 1.53/4.43 = .35

This is how funds like $SPY and $QQQ work.

ETFs can also be active or passive. The above market cap weighted examples are considered passive, with minor portfolio rebalancing taking place within the funds to maintain accuracy relative to the underlying index as company shares rise and fall (more on tracking error later).

Active funds can either be managed discretionary (where managers make all decisions, potentially like our first $ETF example) or systematically (think like a quantitative hedge fund).

Of course, these actively managed products are supposed to produce alpha and have higher fees

Whether an ETF is active or passive, tracks an industry or the whole market, is active or discretionary... they are all still considered open-ended mutual funds that trade on public exchanges and have very similar trading mechanics.

What makes an ETF unique vs. an open end fund or an exchange traded closed end fund is the ability for end-use investors and traders to buy and sell fund shares on the open (secondary) market at approximately the NAV per share of the fund without slippage (inefficient prices)

Traditionally - shares in open end funds were only available through brokers - and I don't mean Robinhood. Mutual funds would sell large blocks of fund shares to large wirehouses (think Schwab, Merrill) who would then sell them to you, of course collecting a fee.

Enter ETFs

When a broker had increased demand among his clients for shares in an open end fund, they would communicate that demand to the fund and it would transact with institutional brokerages to add a proportional amount of the underlying investments to the funds portfolio.

This "creation" should maintain the NAV per share of the fund but raise the overall NAV and assets under management (AUM)

By contrast, a closed end fund has a finite number of shares and they often trade at a premium or discount, which is more or less a judgement on the manager

ETFs were a revolutionary development in equity markets because instead of funds creating or destroying share units at the behest of third-party brokers, now sponsors and their counterparties adjust the NAV of the fund at the end of each trading day to reflect supply/demand.

This process is possible because instead of prime brokers - which most pooled funds usually trade with - ETFs have authorized participants, or APs that assist with maintaining balanced NAV.

Interestingly, APs are not compensated for this work directly, but it has its benefits.

APs are the same institutions that serve as prime brokers - think $JPM securitues, $MS, $WFC, $GS and one ETF can have dozens of them depending on complexity - one that they trade emerging stocks or small caps with.

All AP relationships are based on the same principles though.

The most important concept in the creation/redemption mechanism is the idea of trading fund shares for consistent baskets of stocks, in-kind... meaning that no cash changes hands.

In exchange for providing this service, the APs have access to order flow and other insight.

Consider another $ETF example:

If investors anticipate our three stocks to rise, they could buy shares of $ETF on the secondary market. lets say the closing share price is $77.50 but the U/L stocks didnt change ($75 NAV)

$ETF is trading at a premium and an imbalance is present

$ETF and it's APs now have to make sure NAV per share and secondary share price are within an acceptable range.

The fund would create new shares, trade them to the APs for the U/L stocks, APs then trade them to market makers who sell to the open market, increasing the float.

The increased float will bring down the price for fund shares on the secondary market and the increased assets in the fund would eventually bring NAV/share and secondary share price into equilibrium so investors can buy or sell at a fair price.

This process is repeated daily.

The trades described above constitute the creation mechanism for when there is excess demand for fund shares, and the redemption mechanism is the same but in reverse, with market makers buying weakness on the open market to reduce float, and assets flowing out of the fund.

It is the side-by-side markets and behind the scenes trades that make ETFs unique and allow them to trade with more transparency than other investment products, though that notion has begun to be threatened by special types of ETFs and ETNs which we will discuss later.