ETFs have been branded as mutual funds that trade like stocks.
However, “the funds have different cost structures [than mutual funds]: they don’t require the same infrastructure, servicing and recordkeeping,” says Dean Allen, head of product management for Vanguard Investments Canada. So providers can usually offer lower fees.
ETFs also aren’t constrained by the same supply and demand metrics as stocks. New fund units can be created by market makers (stock market participants who quote both buy and sell prices for stocks, bonds, ETFs or other offerings) in response to demand — so a fund’s trading volume is often more reflective of its popularity, rather than its liquidity.
What ETF market makers do
Let’s say there’s market demand for an ETF replicating the S&P/TSX 60 stock index.
Each day, market makers look at the 60 stocks that make up the index.
“They determine the fair value of the fund by looking at the bid and offer prices of each underlying security,” says Roger Chandhok, associate, global equity derivatives, National Bank Financial. “When they put those values together and divide by the number of outstanding units, they get the value of that basket.”
Market makers also have to consider how many expressions of interest there are to buy and sell each of those 60 stocks, along with the number of individual shares of securities available to buyers and sellers.
Let’s say the value of that basket is $15.30 when the market opens at 9:30. A market maker would set the bid price at $15.29 and the offer price at $15.31. The two cents in the middle is called the spread.
That money helps cover the firm’s costs to transact business on the exchange and offset risks like price changes that occur between the time an order is placed and when a trade executes. Chandhok adds the spread also reflects that each of those underlying 60 securities has its own spread when it trades on the exchange.
Jamie Purvis, executive vice president at Horizons Exchange Traded Funds also points out market makers are required to create and redeem units of the fund. Their “main job is to make sure supply meets demand” and to “ensure the value and price of the funds are essentially the same.”
Allen notes the service market makers provide is important. “[Retail investors] can’t go out and buy 60 stocks at their best offer prices with no friction. They have to pay a commission and spread on each stock. Market makers say, ‘I know all those stocks are worth $15.30 collectively, and I’ll sell them to you for $15.31’ since they’re offering them as a buttoned-up basket.”