I would be really grateful for answers to the following …

  1. When there is a sudden increase in demand for an ETF do the managers have to buy the constituents and thereby push up the price of those so that the EFT's price continues to reflect that of the constituents?
  2. Is this different from a closed-end fund?
  3. Is the price of an ETF a function of sudden changes in volume in the same way that the price of a typical share is influenced by sudden changes in volume?

David Wren-Hardin explains:

  1. An ETF is just a container for a basket of stocks. I'm not sure whom you mean by the manager. If you mean the trust, the trust holds the stocks, but doesn't have to do anything if people buy ETFs on the open market. If people are buying an ETF, though, and a specialist or marketmaker sells them, he will typically hedge with the underlying basket or with the equivalent future. So the buying pressure is passed on. But no one has to buy the underlying.
  2. I believe it's different, because ETFs can be created and redeemed. You can hand the trust the basket of stocks and get ETFs, or you can break up your ETF and get the basket of stocks back. Potentially, the number of ETFs is limited only by the amount of underlying stock in the open market. Mismatches in demand can lead to impaired rebates of ETFs for those who are short, especially around dividend times. Clearing firms will then sometimes create ETFs to ease the impairment for their customers. Or customers will create ETFs themselves to cover it.
  3. The short answer is yes. The ETF and its underlying stocks trade as an arb, and changes in demand quickly move back and forth between the two universes.

Kevin Depew adds:

From the iShares Web site:

iShares ETFs are traded like stocks on an exchange where investors buy and sell them just as they would any other publicly traded security. And because iShares ETFs trade like a stock, investors can benefit from features like intraday pricing and trading, the ability to place stop and/or limit orders, and the opportunity to sell iShares ETFs short.

Like other exchange-traded securities, iShares ETFs will trade subject to a bid-ask spread. Spreads may fluctuate in response to supply and demand forces, overall market volatility, and other factors ? in other words, the same factors that influence the prices and spreads of stocks. But unlike stocks, the ETF's creation and redemption process not only helps to minimize the bid-ask spreads, but may also reduce the premiums and discounts that can develop between the iShares ETF market price and the Net Asset Value (NAV).

ETFs are very different from closed-end funds. A closed-end fund's shares are fixed, which is why they frequently trade at a premium or discount to NAV. Although they both trade on an exchange, the ETF shares can be created and redeemed throughout the day.

Also, it's important to get a handle on the composition of ETFs. The Biotech HLDR, with fewer than 20 members, is two-thirds weighted in AMGN and DNA. On the other hand, IBB, with more than 150 members, is only about 12% weighted in AMGN, has no exposure to DNA. That's a significant difference for two funds labeled Biotech. David Wren-Hardin replies:

Kevin makes a great point. HOLDRS were invented by Merrill Lynch, and unlike other ETFs from the Spyder family (SPY, DIA, XLE, et al.), they never rebalance, and their composition does not change unless a company is taken over or goes bankrupt. That's why AMGN and DNA have taken over the BBH, as opposed to IBB, which is rebalanced from time to time.

In addition, it's more costly to create/redeem out of a HOLDR than a SPY, It costs $10.00 per 100 HOLDRS to create or redeem, That works out to a dime a HOLDR share, a pretty hefty premium. SPY, on the other hand, is a flat $3000.00 charge. The minimum creation unit is 50,000 shares, so that's only six cents, 40% cheaper already. But its $3000,00 for 50,000 or 5,000,000, and at that level the fee becomes a much smaller cost.

Also, HOLDRs pay their dividends straight through. If INTC goes ex-dividend, the owner of the SMH gets the dividend the same day as a regular INTC owner, minus a touch since fees are taken out of the dividend stream. Spyder products and their ilk accumulate the dividends over time, and pay it out quarterly.

Art Cooper remarks:

An excellent resource is Russell Wild's Exchange Traded Funds for Dummies.

Dean Parisian remarks:

I bought into the ETF story early on. So far so good with the love of my financial life, RSP, the Rydex S&P Equal Weight ETF, doing what it is supposed to do.

But all is rosy neither in love nor in the financial markets. I'd like to think I was hoodwinked in shares of USO, the United States Oil Fund. Contango has pinned me down so far, can backwardation bail me out? The fund manager said I should have read the prospectus better.





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