ETF Construction and Management: Important Entities

In the previous articles, we understood what ETFs are and how they are different compared to normal mutual funds. We also understood how we can buy and sell ETFs. Now we will look into more technical details and understand how ETFs are created and how they are managed after their creation. In this article, we will unearth important details about the important entities involved in ETF construction and management.

Important Entities in ETF Construction and Management

Let’s first define some important entities that are involved in the construction and management of ETFs.

Sponsor: This is the issuer and the manager of the ETF. The sponsor is generally the Asset Management Company.

Authorized participants (AP): These are Exchange Participants that provide liquidity to facilitate trading in ETFs. APs can buy/sell directly from AMC in the "Creation Unit" size. APs play a very important role in the entire ETF ecosystem. They are authorized to create and redeem ETF shares. Most ETFs have one or more Authorized Participants. APs are generally big brokerage houses.

Market Makers: These participants may or may not be APs. Market makers also provide liquidity to facilitate trading in ETFs.

AP and market makers are often used interchangeably (in India). But this should not be the case. Market makers perform a much more tactical role in providing daily liquidity. The primary role of AP is to carry out arbitrage trades that keep ETF prices in line with NAV. We will discuss more on this in some of our next articles.

Now that we have a clear idea about the important entities involved, let’s discuss how ETF transactions happen in the secondary market.

ETF Transactions in Secondary Market

Just like a regular stock, ETFs trade in the secondary market (the stock market). The diagram below shows how secondary market transactions work in ETFs.

Pretty simple, just like how regular trading works. Just like stocks, ETFs are traded in secondary markets with bids and asks.

The factors that determine the width of the bid-ask spread are the

• Ongoing order flow
• Competition among market makers for that ETF
• Costs and risks associated with the creation/redemption process (which we will explain in the next article).

Although ETFs trade like stocks, there is one big difference. Stocks are single units, and their market price is their value. ETFs, on the other hand, are baskets of securities, and their value depends on the prices of the underlying securities (closely proxied by iNAV, remember?). At the same time, the market price of an ETF also depends on demand and supply.

There can be times when the market price of an ETF significantly deviates from its underlying value. This is called ETFs trading at a premium/discount to NAV.

In reality, this rarely happens due to arbitrage. Arbitrage is perhaps the most important concept that you should know about ETF's inner workings. Before that, we need to understand the important concept of an ETF creation and redemption mechanism. We will discuss the same in the next article.

FAQs

Are ETFs and Stocks the same?

No, even though both ETFs and stocks are traded on the exchange, they are different. The price of a stock depends on the performance and future projections of its underlying business. On the other hand, the price of ETFs depends on the price movements of their underlying securities, as ETFs are baskets of securities. 

Which are the key entities involved in ETF management?

The important entities involved in ETF management are sponsors, Authorised Participants (APs), market makers, and exchanges.