Investment Ideas

ETFs Explained #3: Trading ecosystem and NAV

ETFs Explained #3: Trading ecosystem and NAV
Published: 12/08/2024

Exchange-traded funds (ETFs) stand out from other types of funds, due to their transparency, liquidity and low costs. ETFs uniquely combine an open-ended structure with on market trading, enabling the supply of ETF units to the market to be increased (creation) or decreased (redemption) depending on investor demand.

While the characteristics of ETFs are well known, we cast a light on some of the key features and players that drive the success of this instrument in our ETFs Explained series.

accordion icon

Creation and redemption

The creation and redemption mechanism underpins many of the potential benefits of an ETF.

The process takes place in the primary market between the ETF issuer and authorised participants (APs). APs are entities chosen by an ETF issuer to obtain the underlying assets needed to create ETF units in large increments. They put together the securities based on their appropriate weightings and deliver them to the ETF issuer; the ETF issuer then holds the securities in a fund. These units are listed or introduced in the secondary market such as a securities exchange where they are traded.

As demand for the ETF rises, more ETF units can be created using this process. In effect, this allows the liquidity of an ETF’s underlying securities to enhance the liquidity of the ETF itself. When demand for the ETF reduces, APs can redeem ETF units by reversing the process. Excess units are sold back to the ETF issuer in exchange for the underlying securities.

This process balances the liquidity of the ETF and allows the market price to closely track the value of its underlying securities, and not be impacted by the demand or supply for the units.

accordion icon

Primary and secondary markets

The creation and redemption process happens in the primary market while ETFs investors largely trade ETFs in the secondary market: a securities exchange or over the counter.

Just like stocks, the price of the ETF changes during trading hours. The price is determined by the value of the underlying securities as well as the transaction costs. Market makers play a key role in setting the price . They also provide bids and offer prices at which investors can trade.

APs work in tandem with market makers by applying for and redeeming ETF units from ETF issuers to meet the supply and demand for ETF units traded in the secondary market.

The two terms - APs and market makers - are often used interchangeably as several firms perform both services.

accordion icon

ETF market pricing, NAV

Unlike mutual funds which may price their shares one time daily , ETFs strike a net asset value (NAV) daily and have real-time prices throughout the trading day.

The NAV is the sum of all its assets less any liabilities divided by the number of units outstanding. It is calculated every day and ETF issuers ensure the value is published at least prior to the start of trading on the next day. It indicates the fair value of a single ETF unit and can give investors a reference point around which they can gauge any offers to buy or sell units of the fund. The NAV, which is disclosed daily, is struck at the close of trading in all the markets in which the ETFs underlying assets trade are listed.

The bid price and the offer price are the prices at which units in the ETF can be bought or sold on the exchange during trading hours.

The creation and redemption process of ETF units while providing the market with liquidity, also keeps the ETF’s share price as close as possible to the value of its underlying assets. The ETF market price and ETF NAV are different due to intra-day changes in price of the underlying securities.

ETF trading ecosystem and NAV

Source: J.P. Morgan Asset Management. For Illustrative Use Only

Know your terms

Authorized Participants: A broker-dealer that is contracted with the ETF issuer to create or redeem shares on behalf of market makers and institutional investors.

Market maker: A dealer that buys or sells at specified prices at all times: also known as liquidity providers.

Primary market: Market where ETF shares are created and redeemed.

Secondary market: An exchange or over the Counter (OTC) where ETF are traded.

J.P. Morgan Asset Management
09sc241511092819
ETF capabilities