How the market prices of ETFs are made

What does the exchange price of an ETF tell me? Why do ETF not develop in the same way the index does? Which price is important for the ETF order? These are questions, many investors (and us) often ask themselves. An explanation. 

One advantage of exchange-traded index funds is that they can be bought or sold as quickly and cheaply as individual shares. Buy and sell offers are permanently available. If two orders match, a price is determined when a deal is closed. With some ETFs this happens several times a minute. In April, the price for the most frequently traded DAX ETF was determined 75,000 times.

However, unlike shares, these prices are not primarily the result of supply and demand for ETF shares. In addition to the value of the fund assets, factors such as costs or trading hours also play a role. But in short term, the market situation still counts a bit. This might sounds contradictory and thus shall be explained in the following. 

To start with: Value on a daily basis 

An ETF, short for exchange-traded index fund, tracks an index. For the investors' money, the securities in the index are bought and sold with the respective weighting they have in the index. 

This can be imagined like a pot of securities, that are themselves listed on the stock exchange and whose prices are constantly changing. The investors' money is paid into this pot and they receive shares in return. Other income of ETFs, e.g. dividends, interest payments or securities lending, also flow into this pot. Costs such as the management fee, trading costs, withholding taxes or dividend payments for distributing ETFs flow out of this pot. The portfolio has a total value based on stock market valuations and cash holdings, which, divided by the number of units in circulation, gives the price per unit. 

This unit price is also known as the net asset value, or NAV, which must be published once a day by fund providers. This applies to all publicly offered mutual funds, whether passively or actively managed. However, the NAV is based on the closing prices of the previous day. *

First acceleration: Minutely rating possible

For ETFs linked to an index, either Deutsche Börse or another service provider calculates the "indicative net asset value", or iNAV, at least once a minute during trading hours. This involves determining the fund assets based on the prices of the individual positions in the fund portfolio and adding up the cash in the fund. The calculated fund assets divided by the number of fund units in circulation are published every minute. For many ETFs, investors can view this value on the data sheet at www.boerse-frankfurt.de. This is much more up to date than the closing price basis from the previous day. 

Flexible trading at the stock exchange without delay 

A major advantage of ETFs is, that they can be bought or sold on the exchange at any time. For this purpose, price offers are permanently quoted. 

These price offers, also known as bid/ask or bid/ask quotes, are generated on the most important marketplace for ETFs, Xetra, by the limit orders of other market participants. A limit order is an order to buy or sell a subject to a price limit. 

Some market participants are Designated Sponsors.They are responsible to quote such prices and to issue or redeem units and to compile the baskets of securities for the portfolio. 

In the open Xetra order book, the orders of the designated sponsors do not differ from the orders of other market participants. However, the Designated Sponsors have committed themselves to comply quality standards with maximum spreads and minimum sizes. In ETF trading on the Frankfurt trading floor, specialists take over the work of Designated Sponsors. 

Intermediate sprint: snapshot of the market 

Therefore, each day there is a net asset value per unit and every minute the indications are available. However, stock exchange prices are based on investors' expectations, which is why supply and demand for units count in ETF trading in the short term. Hence the prices of ETFs can differ from the iNAV and in particular from the NAV. 

The higher the fluctuation margin, the stronger these effects are. Even a low volatility of 15 percent for DAX shares measured against the VDAX-New means an average spread of 1 percent up and down daily. The ETF price can deviate as much from its NAV. These differences are caused by changing investor expectations during the day. It is not only uncertainty, unexpected news or changes in opinion that amplify the effect; different stock exchange opening hours, for example, also have an impact. If the home market for the shares in an ETF is closed, such as Wall Street in our case in the morning, increased risk awareness on the part of the players can increase the price differences. For example, with an ETF you buy a proportion of the 500 US shares in the S&P 500 and your counterparty, the seller, does not know the actual exchange price until trading opens. This can result in a kind of risk premium. 

In the medium to long term, the market prices of an ETF in liquid trading always equal the "intrinsic value" of the assets under management, the NAV. 

Hurdle race: The spread between buy and sell offer

So, when you want to buy or sell an ETF, your order is based on the bid/ask quotes in exchange trading, the buy and sell offers from other investors and the designated sponsors. The difference between these two prices, the trading spread, can also fluctuate. This margin is part of the indirect trading costs. The more active trading and the more market participants are active, the smaller these margins are. Xetra trading with ETFs is characterized by small spreads, which are also reflected in the liquidity measure > Link to article.

Deviations from the track: The tracking error

In the long term, the prices of ETF shares correspond to the value of ETF assets. But although the ETF simply tracks an index, the development of the index and the ETF can differ. 

For one thing, this can have very simple reasons: The index shown is a price index (like most), i.e. the index only shows the pure performance, no inflows such as dividends or interest; and the ETF retains the income. 

If, however, the index and the ETF are comparable and yet differ from each other, this is called a tracking error. This is an unintentional one between the performance of an ETF and its base index. 

A low tracking error is considered a quality feature when comparing ETFs from different providers. Particularly in the case of very long-term investment horizons, the differences can be clearly reflected in the return. 

by Edda Vogt, 
May 2020, © Deutsche Börse

*In his form this applies only to fully replicating ETFs. In the case of partially replicating ETFs, only the largest ETFs are held and in the case of swap-based ETFs, there are settlement agreements with the swap partners in addition to a portfolio of any securities.