I talked with one of our subscribers this weekend and realized that the letter on Friday may have assumed some market experience that all may not have.
We are all familiar with buying stocks. We study a company and decide that we would like to be an owner. We used to call our broker and discuss it with him then place an order to buy the stock. Our broker helped us with money management, sector diversity, asset allocation, stop losses.
Today, most of us have an online brokerage account. These can be with one of the major stockbrokers, or may be with a discount online brokerage company. There are advantages to each, as the major brokerage houses have more research available.
Exchange Traded Funds (ETF’s) are relatively new, having been introduced in the mid 1990’s. The first widely accepted ETF was SPY, which tracks the S&P 500. SPY owns every stock in the index. As a small investor, you can buy one share of SPY, and own an undivided interest in every stock included in the SP500! The stock holdings are weighted and are public knowledge.
This is how the SPY maintains pricing parity to the stocks it represents.
1. If the price of SPY is less than “Net Asset Value”, large institutions can buy SPY shares on the open market then exchange these shares with the ETF creator for underlying index shares; this causes the SPY share price to go up, as supply is reduced.
2. If retail buyers bid up SPY shares above “Net Asset Value”, large institutions can exchange a bundle of the index stocks to the ETF operator in exchange for SPY shares. The institution would then sell these new SPY shares on the market driving down the price, as the supply is increased.
3. These two forms of arbitrage by large institutions keep the ETF priced very close to parity with the value of the underlying stocks.
4. Pricing action is publicly disclosed throughout the day so institutions can evaluate a profit opportunity to either buy SPY shares in the open market to reduce supply, or exchange stocks for “creation” shares to increase supply.
All ETFs follow similar public disclosure, and arbitrage to outside market makers. SPY is the original index fund; it actually owns the shares of the companies in the index. There are ETF’s that track sector indexes, ie: transportation, industrials, technology, consumer goods, utilities, health care, and financials. There are ETF’s that track the Russell 1000, or Russell 2000, or the Dow.
Today we have learned a little about index ETF’s, and how they work. Tomorrow, we will look at Ultra’s, Inverses, Triples, and Back flips. I just made up that last one, but if some of the jokers on Wall Street get a bright idea, we may see it in the coming months.
Disclosure: No Position