Exchange traded funds allow anyone to access broad markets cheaply and efficiently. However, to fully understand how ETFs effectively mimic a basket of securities, financial advisors and investors will need to take a look behind the curtain.
ETFs trade under a so-called Indicative Value Paradigm (IVP), according to Kelly Haughton, Chief Executive Officer of the Global Index Group. ETFs and other open-end funds are priced based on an underlying basket of assets, or net asset value.
Mutual funds calculate their fair value based on the NAV of the closing price in the underlying market. However, ETFs, which trade throughout the day like common stocks, will require a different set of indicative values to help reflect the shifting ETF prices throughout the day.
The indicative value is an important indicator as it allows behind-the-scenes Authorized Participants or market makers to arbitrage potential discrepancies between an ETF’s price and that of its underlying net asset value, so that the ETF will more-or-less trade in line with the value of its underlying basket of securities. [How ETFs Are Traded]
In an attempt to guide trading on ETFs, the indicative NAV or iNAV provides a more real-time view of value throughout the trading day. The iNAV is typically calculated every 15 seconds during normal hours.
If demand for an ETF outstrips supply, the ETF would show a premium to its iNAV. Consequently, a market maker could step in to borrow shares of stock from an underlying benchmark and put them in a trust to form a so-called creation unit of an ETF, which are then sold to the public on the secondary market, alleviating the premium.