What keeps ETF prices aligned with the index?

Question

How do ETFs like VAS ensure their price tracks the index they follow?

I understand there’s rebalancing and "in specie" contributions based on the index, but I don’t see how this guarantees the ETF price matches the index.

For example, if VAS is trading at $85 and the ASX300 is at 6700, what stops VAS from rising to $90 while the ASX300 drops to 6500? Does VAS issue more shares or buy more of the index to align its NAV? And is it traders who keep the ETF price and NAV in sync?

I’m struggling to see how this mechanism works in practice. Can anyone explain?

Answer

Hi Sophie,I’ll give you the broader answer for others who might be reading, then a more specific one.At the top level, it doesn’t really have anything to do with the price of VAS units and the index level itself. Forget about that for a minute, and think about what an index fund actually is.The fund is holding basically the exact proportions of shares that the ASX index has. This means, as shares of CBA, Wesfarmers, Woolies, etc move up and down affecting the index, it will have the very same impact on the shares of VAS too.So because it’s a copycat portfolio, there’s nothing really special it has to do to achieve the same performance as the overall market. It gets more technical obviously because there is money flowing in and out at times, but basically that’s how it works.Now, in terms of NAV vs price…People can obviously pay whatever price they want, but there are ‘market markers’ in the middle (usually financial institutions) that can arbitrage small differences and ensure the price stays basically the same as NAV, as the ‘create/redemption’ comment from AI says.People could then worry about missing out on returns due to this, but when you look at VAS returns vs index over 5-10 years, we can see it’s basically identical and that this functionality works well for investors.Hope that makes sense.Dave

Answer

ETFs like VAS track their respective indices through a combination of methods designed to ensure that the ETF’s price closely mirrors the performance of the index. Here’s how this works in practice:

Rebalancing: ETFs periodically rebalance their holdings to reflect changes in the composition of the underlying index. For instance, if the S&amp;P/ASX 300 index, which VAS tracks, adds or removes a company, VAS will adjust its holdings accordingly. This helps the ETF maintain a portfolio that is representative of the index.

Creation and Redemption Mechanism: This is a key feature that helps align the ETF’s price with its net asset value (NAV). When the demand for an ETF increases, authorized participants (typically large financial institutions) can buy the underlying stocks in the index and exchange them for new ETF shares in a process called «creation.» Conversely, if there’s excess supply of ETF shares, these participants can return ETF shares to the issuer in exchange for the underlying stocks («redemption»). This process helps keep the ETF price close to its NAV.

Market Arbitrage: Traders play a crucial role in keeping the ETF’s price aligned with its NAV. If the ETF’s price deviates significantly from its NAV, arbitrageurs can buy or sell shares of the ETF or its underlying stocks to take advantage of the price difference. For example, if VAS is trading at $90 while the NAV per share based on the underlying index is $85, traders might sell VAS shares and buy the underlying stocks (or vice versa), pushing the price back towards the NAV.

In Specie Transfers: This refers to the transfer of actual securities rather than cash. For ETFs, in specie contributions and redemptions help manage the flow of funds and securities in and out of the ETF without needing to constantly buy and sell the components of the index, which can reduce transaction costs and help better track the index.

In the scenario you described, where VAS is at $85 and the ASX300 is at 6700, if VAS were to rise to $90 while the ASX300 drops to 6500, the discrepancy would likely be quickly noticed by market participants. Traders would engage in arbitrage, and the creation/redemption mechanism would come into play to realign the ETF’s price with the NAV.

Understanding these mechanisms can be complex, but they are fundamental to how ETFs operate and maintain their tracking accuracy relative to their benchmarks. For Pearler users, this understanding can enhance decision-making when selecting ETFs for investment, ensuring choices align with individual investment strategies and goals. Pearler’s platform provides tools and resources that can help investors monitor and analyze ETF performances relative to their benchmarks, aiding in more informed investment decisions.

You can find out more about this topic here: How To Choose The Right Etf

Disclaimer

I am an AI-powered chatbot and not a financial advisor. The information provided is for educational and informational purposes only and should not be considered as financial advice. Investing involves risks, and past performance is not indicative of future results. It is important to conduct thorough research and consider your own financial situation and risk tolerance before making any investment decisions. It is always recommended to consult with a qualified financial advisor or professional before making any investment decisions.

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FIRST TIME INVESTOR

Sophie Wilson.

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Dave Gow - Strong Money Australia

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