Probably a stupid question regarding ETF's

[Eihli]

Is the price of an ETF based off of the price of the companies that are owned by it or by the popularity of the ETF itself? Like, could an ETF be a castle in the sky even if the companies held by it aren't?

I think that's what I'm trying to ask.

[Parallax]

Companies that are owned by it.

[mtgordon]

Really? I certainly have no reason to believe one way or another but I thought that it was traded like a stock. Of course the stock would typically have the value of the companies it holds but I didn't think/know the price was calculated using the company prices.

[gull]

Good question.

The prices of ETFs are not directly pegged to the prices of the stocks. However, people/institutions with enough money (not individual investors) may exchange ETFs for the underlying shares, or vice versa. This exchange mechanism keeps ETF prices relatively in line with the prices of its constituent parts. Arbitragers step in whenever the price steps too far out of line.

When an ETF costs more than the underlying stocks, it's trading at a premium. When an ETF costs less than the underlying stocks, it's trading at a discount.

[wdcbooks]

Gull answered that well. You may also be thinking of closed end funds, which are actively managed mutual funds that may trade at a premium or a discount to their true value.

[emon87]

It theoretically could but it won't trade at much off of the value of underlying shares. Otherwise there would be a potentially for easy arbitrage and such arbitrage would push the price back to equilibrium with the underlying shares values pretty quickly.

[mosdef]

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It theoretically could but it won't trade at much off of the value of underlying shares. Otherwise there would be a potentially for easy arbitrage and such arbitrage would push the price back to equilibrium with the underlying shares values pretty quickly.

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This is true, I think it boils down to the observation that ETFs are exposed to the same kind of "tracking error" risk that mutual funds are, except that the error is driven by traders miscalculating the value of the ETF shares rather than mutual fund managers struggling to replicate an index with a selection of funds.

[spider]

There is a creation/redemption process by which a basket of the underlying stocks can be exchanged (in either direction) for the stock of the ETF. So, just the structure of the ETF itself makes arbitrage reasonably easy (for big investors) and should hence diminish the chance of the ETF getting far from NAV. I don't have a link handy but if you google ETF in combination w/ redemption/creation/in-kind transfer you should find a lot. Barclays also explanins it pretty well at iShares.com.

Also, the ETF will trade throughout the day (simultaneously w/ the underlying assets depending on the particular ETF). I have always thought that provides some extra safety (since it should quickly be obvious if things get out of whack) compared to the end of day trading of mutual funds which effectively means the funds don't trade simultaneously w/ underlying assets (this was a big part of the mutual fund scandal from a few years ago).

[mosdef]

[ QUOTE ]
Also, the ETF will trade throughout the day (simultaneously w/ the underlying assets depending on the particular ETF). I have always thought that provides some extra safety (since it should quickly be obvious if things get out of whack) compared to the end of day trading of mutual funds which effectively means the funds don't trade simultaneously w/ underlying assets

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I don't understand this assertion. When you sell mutual fund units, the sale is processed at the end of day at the end of day unit price based on end of the day market value of the underlying assets. I think they do trade simultaneously, just not at the instant the sale order is issued.

[spider]

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When you sell mutual fund units, the sale is processed at the end of day at the end of day unit price based on end of the day market value of the underlying assets. I think they do trade simultaneously, just not at the instant the sale order is issued.

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OK, but this end of the day trade is not a market transaction the same way an ETF is traded on an exchange. The scandal from a few years ago resulted b/c certain insiders or friends of the MF were able to buy/sell the MF at favorable prices.

I don't really understand the details of how MFs are sold and redeemed to ordinary investors to explain beyond that, but I do feel ETF transactions on an open exchange are (and always will be by design) more transparent and thus less susceptible to fraud than MFs. But don't get me wrong, protections for MF investors are generally pretty good and obviously things like Vanguard index funds were a tremendous boon to the small investor.