How ETFs Work

ETFs seem so simple. Buy the market just like you would buy a stock, follow its value continously during trading hours, and sell any time you like. There are rare capital gains distributions, and management fees are low.

What seems so simple for the investor involves complex system of agreements between different kinds of financial players. The key innovation of an ETF is that it does not invest by purchasing stocks with cash on the open market like a mutual fund. Instead, an ETF is created through a private barter market in which ETFs are traded for stock certificates and redeemed in a reverse exchange.

The whole process starts when a fund manager who wants to launch an ETF submits a detailed plan to the SEC for how the ETF will operate. Legally, ETFs sold in the US are governed by the same laws as mutual funds, and SEC approval is necessary. The fund manager handles all the paperwork and creates demand by advertising and promoting a new ETF.

The next ETF player is the index provider, a firm which specializes in creating and maintaining indexes of stocks which represent attractive asset classes. S&P, Russell, and Dow Jones are among the best known. Clear procedures for determining the target must be published, and the net asset value of the index must be disseminated in real-time.

The next set of players are giant investment houses which have large baskets of stocks available for exchange with an ETF certificate. Often they are closely tied to the fund manager. In practice big institutional money management firms with experience in indexing play this role, such as State Street, The Vanguard Group and Barclays Global Investors. They direct pension funds with enormous baskets of stocks in markets all over the world to loan stocks necessary for the creation process.

The next set of players are authorized participants, also referred to as market makers or specialists. These middlemen borrow the appropriate basket of stocks and exchange them with the ETF fund manager for newly created ETF certificates.

This so-called in-kind trade of essentially equivalent securities is the crucial innovation of ETFs. Because no cash traded hands, the government does not view this as a sale of a capital good. Many industries have this feature. In natural gas, for instance, one producer may exchange gas in a pipeline it owns on the West Coast for gas owned by another producer in a pipeline on the East Coast so that each may supply a customer without transporting the gas across the country. Because the in-kind trade of stocks for ETF certificates does not trigger capital gains, there are no (or rarely) capital gains distributions for investors.

A minor player in all this is the custodial bank which protects investors at all times by holding assets for the fund manager. Exchanges are made in large amounts, sufficient to purchase 10,000 to 50,000 shares of the ETF in question. The custodial bank doublechecks that the basket represents the requested ETF and forwards the ETF shares on to the authorized participant. The custodial bank also holds the basket of stocks in the fund's account for the fund manager to monitor. There isn't too much activity in these accounts, but some cash comes into them for dividends and there are a variety of oversight tasks to perform. Some managers have leeway to use derivatives to track an index.

There are also minor government agencies monitoring the activity. The flow of individual stocks and ETF certificates goes through the Depository Trust Clearing Corp., the same US government agency that records individual stock sales and keeps the official record of these transactions. It records ETF transfer of title just like any stock. It provides an extra layer of assurance against fraud.

Once the authorized participant obtains the ETF from the custodial bank, it is free to sell it into the open market. From then on ETF shares are sold and resold freely among investors on the open market. Investors are the final player in this financial game.

Redemption is simply the reverse. When demand for an ETF shrinks (investors are selling), an authorized participant buys a large block of ETFs on the open market and sends it to the custodial bank and in return receives back an equivalent basket of individual stocks which are then sold on the open market or more typically returned to firms which loaned them.

What motivates each player? The fund manager takes a small portion of the fund's annual assets as their fee, clearly stated in the prospectus available to all investors. The index provider makes money by charging licensing fees to the fund manager. The investment houses which loan stocks to make up a basket make a small interest fee for the favor. The custodial bank makes a small portion of assets likewise, usually paid for by the fund manager out of management fees. The authorized participant profits the creation/redemption process in the difference in price between Net Asset Value of the basket of stocks and the listed ETF price. Whenever there is an opportunity to earn a little by buying one and selling the other, the authorized participant will jump in.

The process might seem cumbersome but it does allow for transparency and liquidity at modest cost. Everyone can see what goes into an ETF, investor fees are clearly laid out, investors can be confident that they can exit at any time, and even the authorized participant's fees are guaranteed to be modest. If one allows ETF prices to deviate from the underlying net asset value of the component stocks, another can step in and take profit on the difference, so their competition tends to keep ETF prices very close to it underlying Net Asset Value (value of component stocks).