The question
When I buy an ETF share, what am I paying for, and who sets the price?
The idea
- An ETF (exchange-traded fund) is a basket of investments split into shares that trade on a stock exchange. Each share has two prices. The NAV (net asset value) is the basket's worth divided by the number of shares, worked out once a day after the market closes. The market price is what buyers and sellers agree on as they trade shares on the exchange, all day.
- The two stay close because of large trading firms called authorized participants (APs). Only APs can create shares (hand the fund a full basket, get new ETF shares back) or redeem them (hand back shares, get the basket).Price above NAV (a premium): an AP buys the basket, swaps it for new shares, and sells them for more than the basket cost, keeping the difference. The extra shares for sale push the price down.Price below NAV (a discount): an AP buys cheap shares, redeems them, and sells the basket for more. Fewer shares for sale lets the price rise.
Worked example
The 4 steps beside the drawing at the top work this through on ETFIQ data. Point at a step to light the part of the drawing it describes.
SPY is an ETF holding the companies in the S&P 500, an index of about 500 large US companies.
The common mistake
"When I buy an ETF, the fund sells me a share at its NAV." That is how a mutual fund works. With an ETF you buy from another investor or a trading firm on the exchange, at the market price, which can sit a little above or below the NAV. For SPY the gap is tiny; lesson 4 shows a fund where it is not.
Check your understanding
Pick an answer to see why. Two of three right passes the lesson.
1. You buy an ETF share at 11 a.m. Who usually sells it to you?Answer: B. Another investor or a trading firm, on the exchange. ETF shares trade between investors on an exchange all day. Not A: the fund deals only with APs; selling to you at NAV is how a mutual fund works.2. A fund's NAV is $50.00 and its shares trade at $50.25. What is this, and what could an AP do?Answer: A. A 0.5% premium; an AP could create new shares and sell them. $0.25 ÷ $50.00 = 0.5% above NAV, so new shares sell for more than the basket costs, and the extra supply pulls the price down. Not B: the price is above the NAV, so it is a premium; redeeming fixes a discount.3. SPY usually closed within 0.06% of its NAV. On a $10,000 purchase, what is that gap at most?Answer: B. $6. $10,000 × 0.06% = $10,000 × 0.0006 = $6. Not C: $60 would be a 0.6% gap, ten times wider than SPY's usual range.
Takeaways
- An ETF share has two prices: the NAV (what the basket is worth) and the market price (what you actually pay).
- APs create and redeem shares to keep the two close; any fund's Trading tab shows how close.
- Turn any gap into dollars: multiply your amount by the percentage.