Two markets inside one ticker

Shares in an exchange-traded fund can change hands thousands of times without the fund purchasing a single additional bond or share. Buyers and sellers may simply exchange ownership of units that already exist. A busy trading screen, then, is not evidence that money is entering the fund.

There are two markets behind the ticker. On the exchange, investors trade shares with one another at quoted prices. In a separate process, authorised participants, usually large financial institutions, can create or redeem blocks of shares directly with the fund. The SEC describes this distinction in its investor bulletin on registered ETFs. This explainer concerns that conventional fund structure; other exchange-traded products can have different arrangements.

Where new shares come from

In a creation, an authorised participant delivers the agreed basket of assets, cash or a permitted combination and receives new ETF shares. A redemption runs the other way: shares return to the fund and the participant receives the specified assets or cash. The basket is determined under the fund's rules; an ordinary retail holder cannot simply demand a chosen slice of the portfolio.

This process creates an economic link between the exchange price and the fund's assets. Suppose, in an invented example, that the assets needed to create a share-equivalent cost £100 while an ETF share can be sold for £101. If the difference exceeds transaction costs and risks, creating shares and selling them is attractive. More available shares and demand for the basket tend to narrow the gap.

A discount can produce the reverse incentive: buy shares, redeem them and sell what comes out. But the arithmetic must use executable prices, fees and the actual redemption basket. A displayed £1 gap is not automatically £1 of profit. Timing, financing and the cost of trading the assets matter.

Net asset value per share, often shortened to NAV in price comparisons, is the value of assets after liabilities divided by the number of fund shares. It is calculated at least each business day for the US-registered ETFs discussed by the SEC. The exchange price is the price at which investors are actually willing to trade. The exchange price need not match the reported per-share NAV at every moment.

When the basket differs from the portfolio

The market disruption of March and April 2020 provided a real test. Bond ETF prices moved substantially away from reported NAVs, and authorised participants did not immediately eliminate the gaps. A subsequent Bank for International Settlements analysis highlighted a structural reason: bond creation and redemption baskets can contain only part of a fund's holdings and can differ materially from one another.

That flexibility helps a manager operate in a market where individual bonds may trade infrequently and in large minimum sizes. It also makes the simple image of exchanging an ETF for an identical miniature portfolio misleading. An arbitrageur needs to price the bonds it will actually receive, including the difficulty of selling them.

There was also a measurement problem. An ETF can trade continuously while some underlying bonds have no fresh transaction price. In its 2021 review of market-based finance, the Bank of England reported preliminary evidence that ETF discounts during the March 2020 stress contained information about subsequent changes in comparable open-ended funds' valuations. It also noted that impaired arbitrage could contribute. An apparent discount could reflect stale bond valuations, difficulty exploiting the gap, or both.

Turnover is not a subscription

Trading volume measures shares changing hands. Net creations and redemptions measure changes through the fund's primary-market mechanism. Assets under management can change because of both flows and the value of existing investments. Treating any one of these as a substitute for the others can turn an accurate number into a misleading story.

The same care applies to liquidity. A tight bid–ask spread on a normal afternoon describes the cost of a particular exchange trade at that time. It does not promise the same spread for a much larger order, during stress or when the underlying market is closed. For an investor reading a fund report, holdings, trading spreads and premium-or-discount history answer different questions.

The first question when ETF activity surges is therefore where it occurred: between investors on the exchange, or between authorised participants and the fund? The next is what the actual basket would cost to trade. A ticker brings the portfolio to an exchange; it cannot make every bond in that portfolio equally easy to sell.