How do funds create more shares?

jedwards · Jul 27, 2009

Just a newbie question, but for example, how does an ETF like FAZ, FAS or UNG create new shares?

From what I gather, the price of the ETF is always reflected by the price of the underlying index, not by the buy-sell demand of the people who are trading the stock.

So how does that work? Does the ETF create and destroy shares on the fly? How do they get the underlying futures contracts of shares so quickly in order to handle this? Is there some place that has that kind of info that describes this?

Thanks in advance!

sjfan · Jul 28, 2009

They don't create new shares. They create all the shares when the trust was created, and shares of the trust are traded.

jedwards · Jul 28, 2009

If the price of the ETF goes up, does it move the price of the things they are linked to? Otherwise there would be a lot of opportunity to arbitrage the differences.

My understanding was that the price of the ETF was based on the underlying basket of things it points to (either the index, or the group of stocks, etc).

If someone came up and bought $10 billion worth of FAZ, would it cause the financials that its pointed to drop, and if so how? What is the underlying mechanics of how the ETF is linked to the underlying shares?

Thanks for any ideas!

black diamond · Jul 29, 2009

Quote from sjfan:

They don't create new shares. They create all the shares when the trust was created, and shares of the trust are traded.

I don't have a source handy, but I think they actually do for equity ETFs. From what I remember there is somebody (maybe the fund itself?) that will exchange new fund shares for the underlying basket and vice-versa. But only in large blocks.

That's why they don't get big premiums/discounts like normal closed end funds .

sjfan · Jul 29, 2009

The only thing that links the price of an ETF to its intrinsic value is arbitrage. For popular indices, because it's relative straight forward, the price of the ETF shouldn't go too far away from its sum of the market value of its underlying. More esoteric stuff (I own a bunch of financial hybrids and high yield loans), the ETF traded prices often drifts appreciably from its true NAV.

Quote from jedwards:

If the price of the ETF goes up, does it move the price of the things they are linked to? Otherwise there would be a lot of opportunity to arbitrage the differences.

My understanding was that the price of the ETF was based on the underlying basket of things it points to (either the index, or the group of stocks, etc).

If someone came up and bought $10 billion worth of FAZ, would it cause the financials that its pointed to drop, and if so how? What is the underlying mechanics of how the ETF is linked to the underlying shares?

Thanks for any ideas!

Szeven · Jul 29, 2009

Quote from black diamond:

I don't have a source handy, but I think they actually do for equity ETFs. From what I remember there is somebody (maybe the fund itself?) that will exchange new fund shares for the underlying basket and vice-versa. But only in large blocks.

That's why they don't get big premiums/discounts like normal closed end funds .

This is true. You can call up ishares or whoever, and they will either redeem units for cash, or you can pay them cash or the correct basket in exchange for units. Each ETF has a creation unit size you must reach, and charge a fee for doing so.

CET · Jul 29, 2009

Quote from sjfan:

They don't create new shares. They create all the shares when the trust was created, and shares of the trust are traded.

If you think they don't issue new shares you are sadly mistaken. UNG has issued more shares several times. I believe those new shares allow them to increase the number of futures contracts they can buy. Their latest request to issue more shares has not been and may not get approved over concerns about UNG's large position in the NG futures market.

sjfan · Jul 29, 2009

I think I was very imprecise with what I said. I meant that they don't issue new shares ala open ended funds. They can of course come to the market with a new issuance like any company can.

Quote from CET:

If you think they don't issue new shares you are sadly mistaken. UNG has issued more shares several times. I believe those new shares allow them to increase the number of futures contracts they can buy. Their latest request to issue more shares has not been and may not get approved over concerns about UNG's large position in the NG futures market.

jedwards · Jul 29, 2009

Thanks for the responses.

So, if I gather this correctly, the ETF has the capability of creating new shares, but it requires a process. It cannot create new shares dynamically on a per day basis?

And the only thing keeping the price of a ETF share to the price of the underlying index/thing it represents is simply arbitrage?

black diamond · Jul 30, 2009

The first page of a google search on "etf share creation" clears this up. Here is the best link I saw:

http://www.icifactbook.org/fb_sec3.html

So basically the ETF publishes a "creation basket". You buy all the shares in the creation basket. Put them in a box and go to the drive through window at the fund company, hand them the box and they hand you a new ETF share. On demand, no cash involved. Something like that anyway.

Sjfan- this definitely not a normal share issuance. BTW, it sounds like you have watched these in the market, how big are the premiums and discounts you see? I know it can get into the double digits with closed end funds, I assumed it was very small with ETFs based on what I have heard but never looked.

Jedwards- This is done dynamically. Maybe you could call this facilitated arb, and it seems like a pretty slick process. It looks like they avoid some of the issues you would get with a normal fixed supply of fund shares - price pressure, liquidity, shorting difficulties when doing the arb transaction.

I am curious if this is universal though, it doesn't look practical for things like commodity ETFs.