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The Creation/Redemption Process Keeps ETF Share Prices Close to the Market Value of the Underlying Shares

The unique feature of ETFs compared to mutual funds is that shares can be created or redeemed in exchange for the basket of underlying stocks. You and I cannot do this, but a number of large financial firms called authorized participants can by transacting with the ETF custodian, as explained next.

All shares of stocks in individual companies need to be housed somewhere. As individual investors, we rarely hold stock certificates for ourselves these days. Rather, a custodial bank or brokerage firm holds shares for us and keeps track of how much it is holding on our behalf. Because ETFs represent partial ownership of a metaphorical basket of stocks, the actual shares in the basket need to be held somewhere, just as our own individual stocks do.

For this purpose, each ETF has a custodian who holds the shares. However, rather than keeping track of which shares belong to which individual investor, all the custodian has to do is make sure that the number of ETF shares in circulation is exactly the right amount for the custodian's holdings of underlying shares. In this regard, an ETF share (in the hands of an authorized participant) is like a claim check. Whoever submits the claim check can retrieve the stored item, which in this case is a basket of stocks. Because all investors know what goods the claim check represents, they can trade claim checks among themselves without needing to inspect the underlying merchandise for each transaction, while the custodian simply guards the merchandise until someone claims it.

Even though ETF shares are traded between investors far more frequently than they are exchanged for the underlying basket of stocks, authorized participants do have the option of switching between ETFs and the actual underlying shares in individual companies. If an authorized participant wants to create shares of an ETF, it can deliver the basket of stocks to the ETF custodian. Conversely, if the authorized participant wants to redeem shares of an ETF, it can deliver the ETF shares to the custodian, who transfers the underlying stocks' shares in exchange. Creation or redemption of ETFs usually occurs in lots of 50,000 ETF shares.

The ability of authorized participants to create or redeem ETF shares in exchange for the underlying stocks gives them a financial incentive to keep the price of ETFs close to the market value of the underlying shares. To see how this occurs, consider the example of an ETF facing a lot of selling pressure. As discussed earlier, an overabundance of sellers drives the ETF price down, regardless of what is happening to the underlying shares.

Let us consider the hypothetical (and unrealistically simple) case of an ETF that holds only one stock—say, shares in GE. The ETF is priced so that one share of GE-ETF equals one share of GE stock. Suppose that panic selling has driven the ETF price a full 1 percent below the market value of its underlying GE shares.

An authorized participant firm happens to own 50,000 shares of GE in its own capital account. This firm, when it perceives the disparity between the GE-ETF and the true price of GE stock, can buy 50,000 shares of GE-ETF at a 1 percent discount and simultaneously sell its 50,000 shares of GE.

At the end of the day, the authorized participant firm asks to redeem its 50,000 shares of GE-ETF. It receives 50,000 shares of GE. The firm started and ended the day with 50,000 shares of GE. But in the course of the day's trading, it locked in a profit of 1 percent.

Obviously, no ETF is created as a basket of one stock. However, authorized participants can achieve the same result with a basket of stocks. If strong selling drives the price of the ETF far enough below the market value of its underlying stocks, an authorized participant can step in and buy the discounted ETF while simultaneously selling (or selling short) the equivalent basket of stocks.

Conversely, if strong buying pushes the price of an ETF far enough above the fair value of its underlying stocks, the authorized participant can sell or short-sell shares of the ETF while simultaneously buying the basket of stocks in the open market.

The process of simultaneously buying and selling essentially identical baskets of stocks in different places at the same time to profit from price discrepancies is called arbitrage. Firms that practice arbitrage help maintain a narrow gap between the ETF's market price and the value of its underlying shares.

The size of the discrepancy between an ETF's price and its fair value depends on the character of the stocks in the ETF. An S&P 500 ETF holds stocks for which there are almost always willing buyers and sellers for a large number of shares. Such stocks are said to be very liquid. All else being equal, it is easier to be an investor in a liquid stock than the opposite—an illiquid stock. Suppose you want to buy $1 million worth of shares in ExxonMobil, a company whose outstanding shares are worth a total of $349 billion. Compared to the entire company, $1 million is an insignificantly small amount, and it is usually easy to find someone with whom to transact. Most of the dollar value of the stocks in the S&P 500 consists of easy-to-trade stocks like XOM. As a result, the cost of arbitrage by an authorized participant is low, allowing S&P 500 ETFs to trade close to their fair values.

On the other hand, an ETF that holds only small company stocks imposes higher costs on arbitrageurs. If you want to buy $1 million worth of stock in a company whose outstanding shares are worth $100 million in total, you have to locate a seller for fully 1 percent of the company's shares. Although in the case of ExxonMobil, it is not hard to find sellers for less than 1/3,000th of 1 percent of a company, it is a far more difficult undertaking to find someone who owns 1 percent of a small company and is willing to sell that much all at once to you. To attract that large a fraction of the outstanding shares, you might have to raise the price you are willing to pay. Conversely, if you want to sell 1 percent of a company's stock, you have to accept a fairly low price to attract that many buyers all at once. Although this is an extreme example, these considerations usually do cause the share price of a small-cap ETF to deviate further from its fair value before it becomes profitable to arbitrage, compared to the situation with large company stocks, which are almost always more liquid.

The market provides two types of information throughout the trading day for you to consult when you are considering making a trade. First are the current bid and ask prices. (If you want to sell immediately "at the market," you should get the bid price. If you want to buy immediately "at the market," you should pay the ask price. In reality, delays in transmitting your order to the exchange might result in your getting a price different from the bid-ask quote you saw when you placed the order.)

The second bit of information is the Indicative Optimized Portfolio Value (IOPV), which in later chapters of this book is referred to by the more descriptive term fair value. IOPV is the fair market value of the underlying basket of stocks in the ETF. This is updated every 15 seconds. Normally, the bid price should be lower than the IOPV, and the ask price should be above it.

To understand why this is, we can turn back to the used car example. There is usually a true wholesale price at which a dealer knows she can buy or sell a car at auction. This price is analogous to the IOPV, which is what the basket of stocks in an ETF is worth in the absence of transaction costs. Generally speaking, a car dealer will not pay more than the auction price to buy a used car and will not sell one off the lot for less, because transacting with other dealers at a car auction remains an option. If a dealer did put up a car for sale for less than the auction price, another dealer could simply buy the car and resell it at auction, pocketing a profit at no risk (again, neglecting transaction costs, which for cars are significant).

Similarly, the ask price on an ETF is what you would have to pay to purchase it. Insiders (authorized participants, specialists, etc.) ordinarily will not sell you an ETF for less than it would cost them to reassemble the underlying basket of stocks through purchases on the open market. If one authorized participant were to ask less for an ETF than the underlying basket of stocks was worth on the open market, which is the IOPV, another trader would snap up the shares at the too-low ask price and simultaneously sell short the underlying basket of stocks at the IOPV, locking in a profit. This actually does occur on rare occasions when one trader's attention might lapse. At such times, other traders swoop in like vultures to take advantage of the riskless profit opportunity. The trader who lets himself get taken advantage of is said to have been picked off, in the language of floor traders.

It is wise to check the IOPV before placing an order. If the bid-ask quote is very different from the IOPV, you might want to try to understand why before making the trade. In some cases, especially when the market is moving quickly, the 15-second delay in updating the IOPV can account entirely for discrepancies between it and the bid-ask quote.

IOPV is reported under a different ticker symbol than the ETF. Other ticker symbols exist for ETFs that report more arcane data, such as the number of shares outstanding, the prior day's closing fair market value, and the cash component of the ETF holdings. (Because the stocks in an ETF pay dividends at various dates, each ETF might have small cash holdings in addition to the basket of shares.)

Good sources of information on the ticker symbols for this additional ETF data are available online from Indexfunds.com4 and from www.amex.com5 (the American Stock Exchange Web site). Barclay's iShares Web site (www.ishares.com) also provides ticker symbols for price quotes and intra-day fair market values for all of its ETFs.

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