How ETFs are valued

As open ended funds, all ETFs feature a continuous primary market for ongoing unit creation and redemption operating simultaneously with a secondary market that is traded on an exchange.

Net Asset Value and Traded Price

Each ETF has two values:

  • The net asset value (NAV) of the units. This is derived with reference to the value of the underlying portfolio of securities and/or other assets that the fund has invested in on the unit holders' behalf. For an ETF that invests in shares or other liquid securities, the net asset value will typically be established once a day after market close.
  • The unit's traded price, which is determined by the bids, offers and sales that occur on ASX's market. The unit's traded price is last traded price throughout the ASX trading day, as is the case with all other securities that trade on ASX.

One of the principal objectives of any ETF is to keep the unit NAV and traded price tracking very closely to one another. All ETFs rely on changing the quantity of units available for trading on ASX's market as a means of achieving this outcome. There are two approaches that are used to achieve this objective, arbitrage and market making.

Arbitrage

Indexed ETFs usually rely on arbitrage between the primary and secondary market to achieve balance between supply of and demand for units on the secondary market and hence deliver a traded price that tracks closely to net asset value.

This is achieved by changing the quantity of units on issue. In kind unit creation and redemption is the mechanism through which the quantity of units on issue can change.

For indexed ETFs, discounts or premiums between the traded unit price and underlying net asset value cannot generally be sustained, as a large investor will typically move to create or redeem units to take advantage of any price discrepancy.

Whilst indexed ETFs may have a designated market maker, the ability to influence the number of units on issue through ordering a unit creation or redemption is generally open to any market participant that has, or is able to assemble the portfolio of shares that is required for a unit creation, or the number of ETF units that is required for a unit redemption.

Market Making

Actively managed ETFs will typically rely on market making to maintaining parity between the unit NAV and traded price. A broker is appointed by the issuer as the 'market maker' to the fund.

The market maker is responsible for providing liquidity to ensure that units trade at fair value. Typically, the market maker presents both buy and sell orders in the market, which closely reflect the fund's NAV.

The market maker typically gives an undertaking to manage the spread between bids and offers, to ensure that investors obtain a fair price to net asset value when buying or selling units in these ETFs.

This approach is not unique to ETFs. It is currently used in ASX's Warrants Market.

Implications for Investors

What do these approaches mean in practice? Indexed ETFs generally don't accept cash applications for unit creations and redemptions. Only large investors that are able to assemble the portfolio of stocks or minimum number of ETF units will be able to apply directly to the issuer to create and redeem units. Investors who are interested in buying and selling units in these ETFs can do so via the ASX.

Actively managed ETFs that rely on the market making approach are typically open for cash applications from small investors as well offering the ability to buy and sell for cash on ASX.