By Jack N., FocusShares® Communications Analyst and Blog Contributor
If you spend any time looking at the world of investments, you can’t help but notice that exchange-traded funds (ETFs) are getting lots of attention. ETFs have been around for nearly two decades, but the industry has seen head-spinning changes in the past five years. Today, you can find ETFs that give you exposure to everything from small U.S.-based companies to crude oil futures and junk bonds.
My intention with this blog, and those to follow, is to provide you with information about ETFs, how they work, and how investors might use them. Today, we’ll look at how ETF shares are created and priced. For some investors it can be confusing, because while ETFs and mutual funds both consist of a basket of securities (such as U.S. stocks or international bonds) the creation and pricing of each differs significantly.
How Mutual Fund Shares are Created & Priced
Mutual fund shares are created by the mutual funds themselves each time an investor puts in an order to buy shares. When an investor sells or redeems their shares they are returned to the mutual fund company. So whether you buy or sell shares through a broker, like Scottrade, or you buy or sell directly from a mutual fund company, the fund creates or redeems those shares.
The price of a mutual fund share is determined by subtracting the fund’s expenses from the market value of the underlying securities and cash, and then dividing that amount by the number of shares. This is also known as net asset value or NAV of the fund.
How ETF Shares are Created & Priced
ETF shares, on the other hand, are not directly controlled by ETF fund sponsors (like FocusShares®, an affiliate of Scottrade). Instead shares initially are created (or redeemed) by stock exchange specialists, called authorized participants (AP). The APs make ETF shares available on stock exchanges, where investors buy and sell them among themselves – just like stocks. That means you can only buy an ETF through a brokerage.
It also means the market price of an ETF is determined by investors, just like stocks, rather than the NAV, like mutual funds. In practice, however, the price of an ETF usually is pretty close to the NAV.
Investors considering ETFs should pay attention to any difference between the NAV price and the market price. If the ETF is selling at premium, or higher than its NAV, that would be a price advantage for sellers. If the ETF is selling at a discount, or lower than its NAV, that would be an advantage for buyers.
It’s important for every investor to read the prospectus of any ETF. But it’s equally important to look at their web pages, too, in your research. That’s where you’ll find the NAV and information on whether a fund is selling at a discount or premium.
Next month, we’ll look at why ETFs are considered “transparent.”
Do you conduct research on ETFs differently than your other investment vehicles?
Jack N. has been with Scottrade since 2011. He is responsible for public relations for FocusShares®.
A prospectus contains this and other information. A mutual fund prospectus is available through www.scottrade.com or through a Scottrade branch office. An ETF prospectus can be obtained directly from the issuer. The prospectus should be read carefully before investing.