Exchange traded funds have helped investors access various markets and assets throughout normal trading hours with the help of a dedicated group of traders working behind the scenes.
ETFs, like traditional open-end funds, represent an investment basket backed by underlying assets, but unlike mutual funds, ETFs are traded throughout the day. Consequently, this allows some to weave between the ETF and underlying markets and to capitalize on potential opportunities, reports Ari I. Weinberg for the Wall Street Journal.
ETFs trade in two markets: the secondary markets that everyone typically monitors on a stock exchange and the primary market where specific authorized participants help create and redeem ETF shares.
Everyone should be familiar with the secondary market as it refers to the on-screen, quotable market that we track through price changes on the stock exchange, similar to tracking a company’s stock. However, ETFs are also traded on a primary market where APs and the ETF sponsor help create and redeem ETF shares for underlying securities or holdings, which occur at the net asset value of the ETF, through so-called in-kind transactions. [How ETFs Are Traded]
Every day, ETF issuers distribute a list of securities and holdings that reflect the basket of stocks, bonds commodities or cash that they will take in exchange for an ETF share. In turn, market makers examine the basket, determine their bids to help best contribute to fluid marketplace and capitalize on the spreads and rebates between the ETF price and its NAV.
“Since the price of an ETF is derived from the price of all the underlying securities, buying or selling a large amount of shares does not have the same impact [as buying an individual security], because those dollars are spread around to all of the underlying securities the ETF is holding,” Edward Rosenberg, head of ETF capital markets for FlexShares, said in the article.
With the proliferation of products, ETFs have become mroe specialized and niche. Consequently, it has become riskier and more expensive for market makers to hedge their exposure. Nevertheless, NYSE Arca has allowed some lead market makers to provide better quotes on specific products in exchange for greater incentives. Additionally, BATS and Nasdaq have adopted incentives programs in encouraging market makers to provide greater liquidity in smaller products. [BlackRock iShares Raising Liquidity in Smaller ETF Offerings]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.