Whoa, okay! So, ETFs have become so so
popular over the last few years because they come with some really nice benefits, such
as diversification, low costs, high liquidity, it's easily accessible and it's super
transparent. But if you are the average investor, they can be a bit of a mystery. You aren't
exactly sure how they work and why the share price between ETFs is so different. Well, today
is the day to find it out. So, let's get it! What's up everyone?! This is fu academy -
your channel for financial education. And on this channel, I share lifestyle, investing-style
and educational videos, just like this one. So, if you are new here, consider SUBSCRIBING! This
is part 2 of my "Mini ETF Series". Part 1 explains the concept of ETFs and their pros and cons. Check
out the video in the link if you haven't already watched it. An ETF is an exchange traded fund. It
makes more sense if we read it backwards: So, it's a "fund" that is "traded" on a stock "exchange".
So, let's first look at how a fund works. Imagine you get together with 2 other friends.
Everyone invests 10,000 dollars. You put all that money in a basket. So, you have 30,000
dollars in total. With those 30,000 dollars, you buy a selection of stocks. The basket
that you have is nothing else than a fund. And to make it fair, everyone gets the same
amount of shares in this fund, because remember: Everyone invested the same 10,000 dollars. Let's
say everyone gets 10 shares. This makes a total of 30 shares. So, in the basket, we have 30,000
dollars divided by 30 shares. It means that each share is worth 1,000 dollars. Let's assume
that the stocks in your fund are now performing really well. Some go up by 5% and others go up by
15%. But on average, the stocks increased by 10%. So, the total investment amount of 30,000
dollars has increased to 33,000 dollars. Now, every share is not worth 1,000 dollar anymore,
but 1,100. Now, let's assume that 1 person out of the 3 of you wants to get out of the fund and
she wants her money back. Now, you have 2 options. Option 1 is that you buy the shares directly
of the person who wants to leave. In this case, she would get her 11,000 dollars and walk off.
The 10 shares of the person who just left will then be split amongst the 2 people that are
still in the fund. This means that the 2 remaining people in the fund get 5 additional
shares each. This will increase the total number of shares per person to 15 with a value
of 16,500 dollars each. So, this was option 1. Option 2 is that you sell the shares of the person
that wants to leave the fund for 11,000 dollars and give that money directly to this person. In
this second scenario, nothing changes for the 2 people that are still in the fund. Both still have
10 shares with a value of 11,000 dollars each. So, understanding this example will really help you
to understand the pricing mechanism of ETFs. Now, let's look at the ETF share price. There can be
different ETF providers that track the same index like the S&P 500. Now you might ask yourself why
they all have different share prices when they track the same thing. To answer this question,
we need to look at how the price of an ETF is calculated. To get to the price of 1 ETF share,
you need to take the value of all stocks included in the ETF and divide those by all ETF shares out
there. Let's actually look at an example and do that together for the iShares Core MSCI World
ETF. If you Google "Core MSCI World iShares", it will bring you directly to the iShares website.
You could first see the name and the price per ETF share for this ETF. If you scroll down, you can
have a look at the historical chart performance. Let's look at the last 5 years here and you can
see that despite the crash of 2020, your portfolio would have grown over that time. Let's move
on to the key facts section. Here, you can see the net asset value of the fund, which currently
is 25.5 billion dollars. If you scroll down more, you will find the number of shares outstanding,
which currently stands at 388 million. If you then divide the 25.5 billion dollars in net asset
value by the 388 million shares outstanding, you will get to the current ETF share price of
65.7 dollars. Now, you might get a feeling why different ETFs that track the same index can
have a different share price. That's because each ETF has a different fund size - so the amount
it invests into companies - and a different number of ETF shares outstanding. But at the end of the
day, it really doesn't matter if an ETF costs 10 or 50 dollars per share. What matters is
the price change, so if it goes up by 10% or down by 10%. Now you might think: "Hold
on! ETFs are traded on the stock exchange. And if they are traded on the stock exchange, then
their share price should be driven by supply and demand!" And that is correct! On the one side, an
ETF tracks the price movement of an index. And on the other side, the ETF share price is driven by
supply and demand. We are about halfway through! If you're getting value in this video, let me know
by hitting that LIKE button! Thank you so much. To understand the relation between the two, we
need to look at the creation and redemption logic. Let's say you want to buy an ETF share. So,
you log into your trading app and you buy this 1 share. Your order will then go through the
stock exchange to a so-called market maker. This market maker will check if there is a seller out
there that can be matched with your buying order. If that's the case, then you will receive the
ETF shares that another person wants to sell. This interaction happens on the so-called
secondary market. In this secondary market, ETF shares exchange ownership, but no new
ETF share is being created in that process. Now, it could be the case though that the demand
for a specific ETF is so high that there are more buying orders than selling orders. To avoid a
situation where a buying order cannot be executed anymore because the market maker is left without
ETF shares, there are authorised participants. I'm going to call them APs. these APs are in direct
contact with the ETF providers and they can create new ETF shares. APs usually work for bigger
banks. But what does an AP do now? They receive a buying list from the ETF provider. That's a list
of all the stocks that the ETF provider wants. The AP then goes out and buys these stocks. These
stocks are then handed over to the ETF provider and in return the ETF provider gives the AP newly
created ETF shares. The AP then gives those newly created ETF shares to the market maker, so to
the stock exchange. And the whole game continues. This process of creating new ETF shares is
called "creation" - makes sense. Redemption is the opposite of this. This happens when
there are too many ETF shares in the market. That's the case when there are more people
that want to sell an ETF share then there are people willing to buy the same share. In
this case, the AP can buy those ETF shares and give them to the ETF provider. In return,
the ETF provider will give the AP the stocks of the companies included in the ETF. The ETF
shares will be eliminated in this process. Now, the AP can sell these stocks in the market. This
whole game of creation and redemption is happening in the primary market, in which ETF shares are
being created and destroyed. Okay, we understand that. But how can the ETF share price be driven
by supply and demand and still track an index? This happens through the interaction
between primary and secondary market. So, the price of an ETF gets determined by
supply and demand on the secondary market. Now, the AP can use arbitrage to make a profit from
this. Let's look at an example to illustrate this. Let's say that the demand for a specific ETF is so
high that the price of this ETF increased a lot. Now, the ETF share is worth more than the
stocks of the companies that it holds. If that's the case, then the AP does the following:
He buys the cheaper companies that are included in that specific ETF and hands them over to the ETF
provider in exchange for newly created ETF shares. The AP will then sell those new ETF shares in
the secondary market for a small profit. Now, let's take a look at what happened here. So,
the AP bought the shares of the companies that are included in the ETF. By doing that, the
AP increased the demand for those shares. Increased demand for a specific product
leads to a higher price. At the same time, new ETF shares were created, which means that
the supply of the ETF shares has increased. If everything else remains the same, increasing
the number of shares will reduce the price of the ETF. This constant interaction has the effect
that the share price of the stocks and the ETF share price are constantly being balanced out.
Now, this all sounds super complicated - and it really is. But this process of creation and
redemption makes sure that ETFs can offer so many of the advantages that we love about them.
The most important one is: It keeps the costs low. And that's because this whole process between
AP and ETF provider is tax efficient. The stocks are not bought and sold between the
2 parties - they are only being exchanged! Stocks of companies against the shares of
the ETF. And that saves both parties a lot of capital gain taxes. This exchange between
stocks and ETF shares brings another advantage: The ETF provider doesn't have to set aside a huge
amount of cash, like active funds for example. Because the selection of the stocks that it tries
to track are not bought and sold - they are being exchanged. Parking cash can be very expensive
because interest rates that you get on this are close to 0%. And that brings down the
total returns of active funds. The cost of running a fund are included in the TER, the total
expense ratio. This is also why ETF funds have an average TER of around 0.16% and why active
funds have an average TER of 0.78%. So, there you have it: The pricing of ETFs. The
most important takeaways are... Number 1: The price of an ETF is calculated by taking
the value of all stocks included in the ETF and dividing it by the numbers of shares. Number 2:
On the stock exchange, so on the secondary market, buying and selling orders meet. No ETF shares
are being created or eliminated. Number 3: APs create new or eliminate existing shares
in the interaction with the ETF provider. Number 4: APs take advantage of the price
differences between the stocks that are included in an ETF and the value of the ETF
shares. Doing that, the AP balances out the price differences between the two. So, I hope
that this video could help you to understand how the pricing of ETFs work. This is actually
one of my first videos. So, if you want to support this channel, then please make sure you SUBSCRIBE!
So, thank you very much for doing that and peace!
