Index fund ETFs

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shahshr
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Index fund ETFs

Post by shahshr »

How do ETFs which mimic a broad index such as S&P 500 ( SPY for example ) follow the index when investors trade these ETFs like regular stock? Won't price-action look different for that ETF than the index when the ETF itself is actively traded as if it is just another ticker?
MrJedi
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Re: Index fund ETFs

Post by MrJedi »

Shares of an ETF can both be created or redeemed from/into the actual stock components. When the price action moves away from the actual NAV of the ETF, authorized participants (think like market maker type institutions) will quickly arbitrage away any significant discount/premium compared to the NAV via this share creation/redemption process.

The authorized participants are motivated to do this as they can pocket the difference for their profit.
alex_686
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Re: Index fund ETFs

Post by alex_686 »

I think you misunderstand how index funds work. Price movements would not cause the index to reconstitute itself. i.e. trade.

Let us say that the fund needs to hold 0.1% of of the free-float market-cap of every company in its index. They go ahead and buy 0.1% of every company out there. Company X jumps up by 100%. The index fund does nothing. They own 0.1% of X. After X jumps by 100% the fund still owns 0.1% of X. Changing prices have no effect.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
livesoft
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Re: Index fund ETFs

Post by livesoft »

Many places are calculating the NAV (or net asset value) of an ETF share in real time as the company shares in the index (and thus in ETF) are traded in real time. No one is going to sell you a share of an ETF that is below its perceived value and you are not going to be able to sell a share above its perceived value either. Whoever you transact with has to agree with you on the price of a share even if you sell or buy at the market with a market order. Think about it.

And yes there are these so-called "authorized participants" that keep things aligned, too. https://www.investopedia.com/terms/a/au ... cipant.asp
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alex_686
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Re: Index fund ETFs

Post by alex_686 »

livesoft wrote: Wed Apr 14, 2021 4:05 pm Many places are calculating the NAV (or net asset value) of an ETF share in real time as the company shares in the index (and thus in ETF) are traded in real time. No one is going to sell you a share of an ETF that is below its perceived value and you are not going to be able to sell a share above its perceived value either. Whoever you transact with has to agree with you on the price of a share even if you sell or buy at the market with a market order. Think about it.

And yes there are these so-called "authorized participants" that keep things aligned, too. https://www.investopedia.com/terms/a/au ... cipant.asp
To refine this...

The fund calculates and publishes the NAV every 15 minutes. They are the only one with the information to do so. It is the only source.

You can, and often, buy the ETF price at something different than the NAV. Usually it is because you are entering the extensional world of "what is a price". A accountant's estimate (NAV) or the market price of the ETF. There are times of circular logic, where you use the ETF price to price the underlying assets which are used to price the ETF. Normally it does not matter - the differences are small and the market is fast. The Authorized Participants normally keep the differences low. But sometimes there is a real breakdown in the market.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
dukeblue219
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Re: Index fund ETFs

Post by dukeblue219 »

alex_686 wrote: Wed Apr 14, 2021 3:56 pm I think you misunderstand how index funds work. Price movements would not cause the index to reconstitute itself. i.e. trade.

Let us say that the fund needs to hold 0.1% of of the free-float market-cap of every company in its index. They go ahead and buy 0.1% of every company out there. Company X jumps up by 100%. The index fund does nothing. They own 0.1% of X. After X jumps by 100% the fund still owns 0.1% of X. Changing prices have no effect.
Yes, but that's not really the question, which was posed for ETFs specifically. If one places a market buy order for $10B worth of SPY it will drive the price up well beyond the true value of the underlying shares. That's a factor unique to ETFs compared to funds.

As previously answered, there are big players who will arbitrage away the differences before they get too big.
alex_686
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Re: Index fund ETFs

Post by alex_686 »

dukeblue219 wrote: Wed Apr 14, 2021 4:44 pm
alex_686 wrote: Wed Apr 14, 2021 3:56 pm I think you misunderstand how index funds work. Price movements would not cause the index to reconstitute itself. i.e. trade.

Let us say that the fund needs to hold 0.1% of of the free-float market-cap of every company in its index. They go ahead and buy 0.1% of every company out there. Company X jumps up by 100%. The index fund does nothing. They own 0.1% of X. After X jumps by 100% the fund still owns 0.1% of X. Changing prices have no effect.
Yes, but that's not really the question, which was posed for ETFs specifically. If one places a market buy order for $10B worth of SPY it will drive the price up well beyond the true value of the underlying shares. That's a factor unique to ETFs compared to funds.

As previously answered, there are big players who will arbitrage away the differences before they get too big.
Oh, well, then I misunderstood the question.

Yes, it would move the price. However the market is liquid and deep. There are other options out there besides the APs. There are lots small of arbitrage plays out there as well using the actual securities, futures, options, statistical arbitrage, etc.

Nobody would just dump a 10b market order. It is a game of cat and mouse.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
secondopinion
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Re: Index fund ETFs

Post by secondopinion »

alex_686 wrote: Wed Apr 14, 2021 4:39 pm
livesoft wrote: Wed Apr 14, 2021 4:05 pm Many places are calculating the NAV (or net asset value) of an ETF share in real time as the company shares in the index (and thus in ETF) are traded in real time. No one is going to sell you a share of an ETF that is below its perceived value and you are not going to be able to sell a share above its perceived value either. Whoever you transact with has to agree with you on the price of a share even if you sell or buy at the market with a market order. Think about it.

And yes there are these so-called "authorized participants" that keep things aligned, too. https://www.investopedia.com/terms/a/au ... cipant.asp
To refine this...

The fund calculates and publishes the NAV every 15 minutes. They are the only one with the information to do so. It is the only source.

You can, and often, buy the ETF price at something different than the NAV. Usually it is because you are entering the extensional world of "what is a price". A accountant's estimate (NAV) or the market price of the ETF. There are times of circular logic, where you use the ETF price to price the underlying assets which are used to price the ETF. Normally it does not matter - the differences are small and the market is fast. The Authorized Participants normally keep the differences low. But sometimes there is a real breakdown in the market.
Real breakdowns do happen. I know this very well.
It is better to be half-wrong than have a 50% chance of being all-wrong. With the former, you will learn and have money to try again. Otherwise, you will never learn and will have nothing eventually.
Topic Author
shahshr
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Joined: Thu Nov 30, 2017 11:29 am

Re: Index fund ETFs

Post by shahshr »

Wonderful discussion and thanks a ton to all for sharing this knowledge.

I am new to finance world and had to look up terms like arbitrage and NAV to make sure what I was inferring from the sentences was true :-). I've been buying/selling SPY ETF and had this question which I was not able to get answer to, so asked here and glad that I did that.

Nuggets like 'NAV is published every 15 mins' and 'APs work diligently to keep differences low' and the fact that 'real breakdowns DO occur' are something I could not have found by other means available to me, I guess.

I still don't fully understand sentences like (paraphrasing): "APs will quickly arbitrage away any significant discount/premium compared to the NAV via this share creation/redemption process." and "APs are motivated to do this as they can pocket the difference for their profit." (I mean if that is possible, it might be in AP's interest that breakdowns occur frequently in a way that they can make more money)

Will try reading more on the links posted in one message to see if I can understand better.

Thanks!
MrJedi
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Re: Index fund ETFs

Post by MrJedi »

shahshr wrote: Thu Apr 15, 2021 8:55 am I still don't fully understand sentences like (paraphrasing): "APs will quickly arbitrage away any significant discount/premium compared to the NAV via this share creation/redemption process." and "APs are motivated to do this as they can pocket the difference for their profit." (I mean if that is possible, it might be in AP's interest that breakdowns occur frequently in a way that they can make more money)
There are multiple APs, so they are competing for that arbitrage once it's worthwhile for them to do the work in creating/redeeming shares. If one AP waits too long, another will come in to take it. This competition helps things stay aligned.
alex_686
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Re: Index fund ETFs

Post by alex_686 »

shahshr wrote: Thu Apr 15, 2021 8:55 am I still don't fully understand sentences like (paraphrasing): "APs will quickly arbitrage away any significant discount/premium compared to the NAV via this share creation/redemption process." and "APs are motivated to do this as they can pocket the difference for their profit." (I mean if that is possible, it might be in AP's interest that breakdowns occur frequently in a way that they can make more money)
If you want to go deep down the rabbit hole, here is a good book: A Comprehensive Guide to Exchange-Traded Funds by Joanne M. Hill et. al.

Amazon has the kindle version for free and you should be able to find a free PDF version if you google around.

Arbitrage is a risk free trade that makes money.

Lets say the ETF is trading for $100 but the underlying basket of stocks is trading for $101. A arbitrage trader (in this case, the AP) will buy the ETF, exchange the ETF shares for the underlying basket of shares, then sell the shares. This results is a risk free $1 profit.

[EDIT] This free money drives trades that narrow the difference between the ETF price and the basket of underlying stocks.

One of the measures of how efficient a ETF is by comparing the difference between the NAV price and market price. SPY is razor thin.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
Topic Author
shahshr
Posts: 7
Joined: Thu Nov 30, 2017 11:29 am

Re: Index fund ETFs

Post by shahshr »

MrJedi wrote: Thu Apr 15, 2021 9:26 am There are multiple APs, so they are competing for that arbitrage once it's worthwhile for them to do the work in creating/redeeming shares. If one AP waits too long, another will come in to take it. This competition helps things stay aligned.
Thanks! Makes sense.
Topic Author
shahshr
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Joined: Thu Nov 30, 2017 11:29 am

Re: Index fund ETFs

Post by shahshr »

alex_686 wrote: Thu Apr 15, 2021 9:45 am
If you want to go deep down the rabbit hole, here is a good book: A Comprehensive Guide to Exchange-Traded Funds by Joanne M. Hill et. al.

Amazon has the kindle version for free and you should be able to find a free PDF version if you google around.

Arbitrage is a risk free trade that makes money.

Lets say the ETF is trading for $100 but the underlying basket of stocks is trading for $101. A arbitrage trader (in this case, the AP) will buy the ETF, exchange the ETF shares for the underlying basket of shares, then sell the shares. This results is a risk free $1 profit.

[EDIT] This free money drives trades that narrow the difference between the ETF price and the basket of underlying stocks.

One of the measures of how efficient a ETF is by comparing the difference between the NAV price and market price. SPY is razor thin.
Wonderful. Thanks for explaining how arbitrage works. The ETF book looks good, and for some reason, it was free on Kindle. Got it.
alex_686
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Re: Index fund ETFs

Post by alex_686 »

shahshr wrote: Fri Apr 16, 2021 8:50 am Wonderful. Thanks for explaining how arbitrage works. The ETF book looks good, and for some reason, it was free on Kindle. Got it.
The CFA Institute cranks out lots of good stuff aimed at the professional practitioner. As such they tend to be low cost or no cost. Free PDFs can often be found.

Another free one that I like very much is: Financial Market History: Reflections on the Past for Investors by David Chambers et. al.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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