How Does ETF Pricing Work?

Ever wonder how ETF share prices remain in line with the current prices of the underlying stocks? The process is quite simple really although the execution might seem quite complex.

Introducing the Market Makers

First off, it's important to know that there are people who play the role of market makers. These people order the creation and redemption of ETF shares. An ETF share is built from the shares of the companies in the underlying index. Sometimes the index is a well-known one such as the S&P 500, but arguably an index can be anything the ETF has chosen to follow even if it's of its own design.

So when there's demand for the shares of the ETF, a market maker will step in to create them. And when necessary, a market maker will redeem shares of the ETF.

The motivation for market makers is that, during this process of creation and redemption, they can arbitrage premiums or discounts to the underlying net asset value. That is, if there's a discrepancy between the value of the ETF share and the value of the underlying holdings, there's a potential to make a profit with next to no risk. As such, the price of the ETF constantly moves up and down pretty much in real-time with the prices of the underlying shares.

In case you're thinking you should get into the market making game, be aware that we're talking about significant sums of money per individual transactions. As such, market makers are typically bank-owned investment dealers.

The Process

Let's say there's an investor looking to add some ETF shares to his or her holdings. When the transaction is placed, the market maker doesn't have enough units to fill the order so new units are needed. In this case, the market maker credits the buyers account while simultaneously purchasing the underlying ETF stocks in an amount that matches your investment.

The market maker then delivers these shares to the ETF company (e.g. BlackRock), which responds by issuing new units equal in value to the underlying shares. In the end the market maker doesn't hold any of the underlying shares and has made a tiny profit.

A Win-Win

With the risk being small and the power of computing to make execution cheap, this behind-the-scenes trading attracts enough interest to result in a tidy, self-maintaining system that keeps everything in balance. The market markers benefit by making a profit and investors benefit from having differences between net asset values and ETF values being kept to a minimum. It's as close to a win-win situation in the investing world as you're likely to get.

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