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An Exchange Traded Fund (ETF) represents a basket of securities. Shares of an ETF can be bought and sold on an exchange like common stock. So how can investors be sure that the market price they pay for a share of an ETF accurately reflects the value of that basket of stocks? This article describes the mechanisms in place to keep them in balance.

Net Asset Value vs. Market Price

An ETF’s Net asset value (NAV) represents the value of the securities it holds (including cash), less its liabilities, divided by the number of shares outstanding.

ETFs trade at market price, which is the price of the last reported trade on the fund’s primary exchange. An ETF’s market price might be different than NAV.

There are two things that all ETFs have in common that help minimize that difference. They are:

  1. Pricing transparency
  2. Variable shares outstanding

While this list is small, these two features are part of what makes ETFs so popular.

Pricing Transparency

To trade on an exchange, an ETF must have a unique identifier, called a ticker symbol.

An ETF’s ticker symbol allows investors to track price movement throughout the day.

The exchange on which the ETF trades provides intraday price data while the market is open. This visibility into an ETF’s market price is an important component of its broader price transparency.

ETFs also publish estimates of their NAVs during regular market hours. This estimate is referred to as Intraday Indicative Value (IIV) and the calculation is made in near real time.1

Reporting market price and IIV throughout the day contributes to keeping them in sync and provides investors with a reference point when buying or selling shares. When the gap between the two is wide, large, institutional market participants will take advantage of those price discrepancies.

These institutional investors can profit from simultaneously buying or selling ETF shares and the underlying basket of securities. They will buy ETF shares and sell the basket of securities when market price is at a discount to (less than) IIV. They will do the opposite when market price is at a premium to (more than) IIV.

This is referred to as arbitrage and it helps maintain a balance between an ETF’s market price and its NAV.

Variable Shares Outstanding

Because ETF shares trade on an exchange, the ETF issuer isn’t involved in purchase and sale transactions. But when there is a large imbalance between buyers and sellers, a mechanism exists to prevent an ETF’s market price from straying too far from its NAV.

Changes occur as needed based on supply and demand.

For example:

  • When demand is high, ETF shares are introduced to the market
  • When demand is low, shares are removed from the market

This ongoing process, referred to as creation and redemption, is part of a contractual relationship every ETF issuer maintains with large institutional investors (call “Authorized Participants”) that are tasked with “helping to ensure ETF investors are treated equitably when buying and selling fund shares.”2

The combination of arbitrage activity and ETF share creation and redemption helps keep market price in line with NAV. This is why price differences are typically small and short-lived.

So what are the benefits of these two features for individual investors?

Benefits to Individual Investors

The mechanisms that seek to align market price and NAV may help provide investors with confidence that ETFs have a reasonable place in a properly diversified portfolio.

Because they are traded on an exchange, ETFs deliver liquidity and flexibility to help people invest for their specific goals and objectives.

For example, ETFs can be used to:

  • Construct a conventional asset allocation of stocks and bonds
  • Augment a traditional mix to include alternative asset classes
  • Add to desired exposures during short-term price declines

ETFs give investors the ability to invest in ways that are appropriate for their individual financial objectives and risk tolerances, among other possible factors.

For more helpful information about ETFs, visit our Investor Learning Center.

1 Approximately every 15 seconds. IIV is also referred to as Indicative Optimized Portfolio Value (IOPV) depending on the exchange where the ETF is traded.

2 Source: Securities and Exchange Commission, 17 CFR Parts 210, 232, 239, 270, and 274, Release Nos. 33-10695; IC-33646; File No. S7-15-18], RIN 3235-AJ60, Exchange-Traded Funds, Final rule, Page 14.

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