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How do ETFs work?

September 28, 2016

You've probably heard exchange-traded funds (ETFs) described as a basket of securities that can be bought and sold like stocks. But have you ever wondered about the mechanics that enable ETFs' trading flexibility?

Richard Powers"There are two key concepts to understanding what makes an ETF work: first, creation and redemption, the process by which ETFs are bundled; and second, the role of authorized participants (APs), the parties that transact in that process," said Richard Powers, the head of ETF product management in Vanguard Portfolio Review Department. "The resulting price convergence between an ETF and its respective basket of securities is what facilitates intraday trading of ETFs."

What is an ETF?

Very simply, an ETF is a wrapper, a vehicle that contains not only a basket of securities, but also a philosophy and process to invest stock or bond holdings. From this perspective, ETFs and mutual funds are the same.

For example, whether you purchase an S&P 500 index fund through a mutual fund or an ETF, you're investing in the same underlying securities. Both investment vehicles will hold all (or most) of the 500 stocks in the same proportion as the index the funds seek to mirror.

How are ETFs and mutual funds different?

The most important difference between ETFs and mutual funds is how you buy and sell them. In other words, they are more similar than different.

"The "E" and "T" in ETF stand for exchange-traded. That is, ETFs can be bought and sold throughout the day, the same way stocks are traded on a market exchange. While the "F" stands for fund, as in mutual fund," Powers explained.

This intraday liquidity offers flexibility and greater control over when and at what price you can trade ETFs. In contrast, mutual funds trade once a day, at the end of day.

Balance supply and demand with creation and redemption

The creation and redemption mechanism and the role of APs are two key concepts that enable ETFs' intraday liquidity. Creation and redemption is the process by which ETFs are packaged and deconstructed.

Authorized participants, typically large institutional investors, create and redeem the baskets of securities. These market makers play an integral role in supplying liquidity and keeping ETF prices aligned with the market value of the underlying assets throughout the trading day.

When rising demand causes ETF prices to rise higher than the value of the ETF holdings (i.e., trade at a premium), the role of APs is to buy the underlying securities, exchange them for ETF shares, and then sell those shares into the market. Conversely, if falling demand causes ETF prices to trade too low (i.e., at a discount), an AP may buy shares of the ETF in the market and redeem them in exchange for the underlying securities.

"When the value of the underlying securities increases, so should the value of the pooled security, whether a mutual fund or an ETF. These arbitrage activities among authorized participants help keep ETF prices aligned with the market value of the basket of securities," said Powers.

Look under the hood

ETFs offer an attractive and efficient way for investors to implement an investment strategy. So do mutual funds. The broad diversification and low-cost feature of ETFs are characteristics that can be tied to their index-based structure. So before you decide on an ETF or a mutual fund, focus your research on investment objectives and your need for trading flexibility. Because whether you decide to go with an ETF or mutual fund invested in the same strategy, chances are you'll find the same securities when you look under the hood. 

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Vanguard ETF Shares are not redeemable with the issuing fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
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