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How do ETFs reflect the growth of an asset

Just like any other listed stock you might own, one of the primary goals of an exchange traded fund (ETF) is to increase in value over time. It's not rocket science, you know your stocks are performing well if the price they're trading at continues to exceed the price you originally bought them for.
By · 21 Dec 2020
By ·
21 Dec 2020 · 5 min read
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However, what’s less well understood is how the growth of the underlying assets (a la the stocks it’s invested in) ultimately finds its way to the ETFs that you own.

For starters, the share price an ETF trades at is largely determined by the underlying value of the stocks within its portfolio (~ typically referred to as the Net Asset Value or NAV). Secondly, it’s important to know that the NAV or official value per share of an ETF - based on underlying securities’ closing prices - can vary from an ETF’s market price.

How growth is captured via an ETF

Think of the NAV as the value of all the stocks held by the ETF - such as shares or bonds and cash, minus any liabilities, like expenses - and divided by the number of shares outstanding. The NAV of an ETF will go up (or down) depending on the overall performance of the underlying stocks that it owns.

Given that an ETF’s NAV is calculated independently, during and then again at the end of each trading day – based on the most recent closing prices - it will consistently reflect the growth (or losses) of the underlying stocks held within it.

As a result, any plain vanilla ETF that tracks a common index of highly traded securities should always be priced at or very close to the net asset value (NAV).

In very crude terms, here are two primary determinants of an ETF’s price per share.

  • If the value of an ETF’s underlying assets goes up, and the number of shares remains (relatively) unchanged, then the price per share will also increase, alternatively:

 

  • If trading demand for an ETF’s shares increases, then more units are created by the provider, and increased supply of shares keeps the share price in line with the ETF’s NAV. By comparison, in the markets for direct shares in listed companies – which is fundamentally different to units of ETFs - demand for more shares than were offered in the market would only drive the price up.

 

Market maker ensures ETFs trade at NAV

If the difference between bid and offer price, known as the spread, starts to widen, for any number of reasons - including time-lag between markets, liquidity or supply and demand - an ETF will typically choose to use what’s called a ‘market maker’ facility to buy or sell units. It’s the job of the market maker to ensure that bids and/or offers are met, while not straying far from NAV.

While the premiums and discounts to an ETF’s NAV are usually negligible for the vast majority of ETFs, they can be accentuated during bouts of greater market volatility, like we’re currently experiencing.

But there’s no need to panic, by applying a market marker to its portfolio of ETFs, InvestSMART ensures there’s always sufficient liquidity to create and redeem units at the buy/sell price when required. By consistently trading at or very near their NAV –InvestSMART ETFs will always reflect all the growth of its underlying assets.

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Frequently Asked Questions about this Article…

ETFs reflect the growth of their underlying assets through their Net Asset Value (NAV), which is calculated based on the performance of the stocks or bonds they hold. As the value of these assets increases, the NAV of the ETF goes up, and this is reflected in the ETF's share price.

The Net Asset Value (NAV) of an ETF is the total value of all the stocks, bonds, and cash it holds, minus any liabilities, divided by the number of shares outstanding. It is a key indicator of the ETF's value and is calculated independently during and at the end of each trading day.

An ETF's market price can differ from its NAV due to factors like trading demand, liquidity, and market volatility. However, these differences are usually minimal because market makers work to ensure that the ETF's price stays close to its NAV.

If trading demand for an ETF's shares increases, more units are created by the provider to meet this demand, keeping the share price in line with the ETF's NAV. This mechanism helps maintain price stability, unlike direct shares in listed companies where increased demand can drive prices up.

Market makers help ensure that an ETF's trading price remains close to its NAV by buying or selling units as needed. They manage the bid and offer prices to maintain liquidity and prevent significant deviations from the NAV, especially during volatile market conditions.

Yes, market volatility can cause premiums or discounts to an ETF's NAV to become more pronounced. However, these are typically negligible for most ETFs, and market makers work to minimize these discrepancies by ensuring sufficient liquidity.

An ETF's NAV is calculated independently during and at the end of each trading day based on the most recent closing prices of the underlying securities. This frequent calculation helps ensure that the ETF accurately reflects the growth or losses of its assets.

If the spread between an ETF's bid and offer price widens, a market maker may step in to buy or sell units to ensure that the ETF's trading price remains close to its NAV. This helps maintain market stability and investor confidence.