How ETFs Are Created and Managed: A Guide to Smart Investing

The Building Blocks of Modern Investing

In today’s investing world, ETFs have become one of the most popular investment vehicles. They’re celebrated for their diversification, ease of trading, and cost efficiency. But what makes them tick?

The creation and management of ETFs are not just about assembling stocks or bonds; it’s a carefully orchestrated process that allows investors to trade a slice of the market with just a few clicks. Understanding this process can add clarity to your investing journey and help you make more informed decisions.

As of October 2024, there are 3,512 exchange-traded funds (ETFs) in the United States. This reflects a consistent increase, with a 15.49% growth compared to the previous year and a increase of 64% from September 2020, when there was 2,136 ETFs in the United States. The popularity of ETFs continues to grow due to their flexibility, diversification, and accessibility for investors​

The 10 most popular ETFs based on assets under management (AUM) are often considered benchmarks for specific market segments due to their size, liquidity, and low expense ratios. Here are some of the top ETFs by AUM as of late 2024:

SPDR S&P 500 ETF Trust (SPY)

• Tracks the S&P 500 Index.
• AUM: $590.7 billion.
• Expense Ratio: 0.095%.

Vanguard S&P 500 ETF (VOO)

• Tracks the S&P 500 Index.
• AUM: $540.8 billion.
• Expense Ratio: 0.03%.

iShares Core S&P 500 ETF (IVV)

• Tracks the S&P 500 Index.
• AUM: $540.7 billion.
• Expense Ratio: 0.03%.

Vanguard Total Stock Market ETF (VTI)

• Tracks the CRSP US Total Market Index, covering the entire U.S. equities market.
• AUM: $438.6 billion.
• Expense Ratio: 0.03%.

Invesco QQQ Trust (QQQ)

• Tracks the Nasdaq-100 Index, focusing on technology and non-financial companies.
• AUM: $294.7 billion.
• Expense Ratio: 0.20%.

Vanguard Growth ETF (VUG)

• Focuses on U.S. growth stocks.
• AUM: $143.1 billion.
• Expense Ratio: 0.04%.

Vanguard FTSE Developed Markets ETF (VEA)

• Targets developed markets outside the U.S. and Canada.
• AUM: $137.6 billion.
• Expense Ratio: 0.05%.

Vanguard Value ETF (VTV)

• Focuses on U.S. value stocks.
• AUM: $127.3 billion.
• Expense Ratio: 0.04%.

iShares Core MSCI EAFE ETF (IEFA)

• Tracks developed markets outside North America.
• AUM: $121.3 billion.
• Expense Ratio: 0.07%.

iShares Core U.S. Aggregate Bond ETF (AGG)

Expense Ratio: 0.03%.

Tracks the performance of the U.S. bond market.

AUM: $117.7 billion.

How ETFs Are Created and Managed

ETFs, or Exchange-Traded Funds, are created and managed to offer investors a diversified and efficient way to invest in a range of assets. Unlike individual stocks or bonds, an ETF holds a basket of assets, and its shares trade on exchanges like individual stocks. But creating and managing these financial products is a process that combines expertise, strategy, and market dynamics.

The Creation Process: Bringing an ETF to Life

a. Role of the Issuer
The ETF creation process begins with an issuer, typically a fund management company or financial institution (e.g., Vanguard, BlackRock). The issuer defines the ETF’s investment objective, choosing an underlying benchmark or asset class—such as a stock index, sector, or commodity—to track. The issuer also determines the fund's structure, such as passive (index-tracking) or active (manager-driven) management.

b. Collaboration with Authorized Participants (APs)
Authorized participants (APs) are institutional investors or financial firms (e.g., investment banks) authorized to create or redeem ETF shares. These APs assemble the underlying assets of the ETF, such as stocks or bonds, and exchange them with the issuer for ETF shares in a process known as in-kind creation.

This in-kind exchange keeps costs low by avoiding cash transactions and helps the ETF closely track the net asset value (NAV) of its underlying assets.

c. Distribution to Investors
Once the ETF shares are created, APs sell them on stock exchanges, making the ETF accessible to retail and institutional investors. The shares trade just like individual stocks throughout the trading day.

Management and Ongoing Operations

a. Passive vs. Active Management

• Passive ETFs: These track an index and require minimal human intervention. The fund manager ensures that the ETF’s holdings are rebalanced regularly to match changes in the underlying index. For example, if a company is added to or removed from the S&P 500, an ETF tracking the index will adjust its holdings accordingly.
• Active ETFs: These are actively managed by portfolio managers who select assets to outperform a benchmark or achieve specific investment goals. This approach requires ongoing decision-making and portfolio adjustments.

b. Rebalancing and Maintenance
Even for passive ETFs, portfolio rebalancing is essential to maintain alignment with the target index. Management also involves:

• Reinvesting dividends from the underlying assets.
• Managing corporate actions (e.g., stock splits, mergers).
• Ensuring that the ETF’s NAV accurately reflects the value of its holdings.

c. Role of APs in Ongoing Liquidity
APs play a pivotal role in ETF liquidity. If demand for an ETF rises, APs can create additional shares by delivering more of the underlying assets. Conversely, if demand falls, APs redeem shares by returning the ETF shares to the issuer and receiving the underlying assets.

Liquidity, Pricing, and Market Dynamics

a. Intraday Liquidity
Unlike mutual funds, which are traded at the end-of-day NAV, ETFs can be bought and sold throughout the trading day at market prices. This intraday liquidity is one of their key advantages, allowing investors to react to market conditions in real-time.

b. The Role of Market Makers
Market makers ensure that there are always buy and sell quotes for ETF shares. This contributes to efficient price discovery and reduces bid-ask spreads, making ETFs more accessible for retail investors.

c. Price and NAV Alignment
The price of an ETF is determined by market demand and supply. However, it typically stays close to its NAV due to the arbitrage activities of APs. For example:

• If the ETF price rises above its NAV, APs can create new shares at NAV, sell them on the market at the higher price, and pocket the difference.
• If the price falls below NAV, APs can redeem shares for the underlying assets, profiting from the discrepancy.

This arbitrage mechanism ensures that ETF prices remain fair and reflective of the underlying assets.

Differences of ETFs and Mutual Funds

ETFs (Exchange-Traded Funds) and Mutual Funds are both investment vehicles that pool money from investors to invest in a diversified portfolio of assets. However, they differ in key aspects, including how they are traded, managed, and structured. Here’s a comparison:

1. Trading

• ETFs
  • Trade on stock exchanges like individual stocks.
  • Can be bought and sold throughout the trading day at market prices.
  • Prices fluctuate based on supply and demand, similar to stocks.
• Mutual Funds
  • Bought and sold directly from the fund company or through a broker.
  • Trades are executed only once per day after the market closes, at the fund’s net asset value (NAV).

2. Management Style

• ETFs
  • Predominantly passively managed (e.g., tracking an index like the S&P 500).
  • Some actively managed ETFs exist but are less common.
• Mutual Funds
  • Can be either actively or passively managed, but active management is more prevalent.
  • Actively managed mutual funds aim to outperform the market, often resulting in higher fees.

3. Costs

• ETFs
  • Tend to have lower expense ratios due to passive management and operational efficiencies.
  • Investors pay trading commissions (if applicable) when buying or selling ETF shares.
• Mutual Funds
  • Typically have higher expense ratios, especially for actively managed funds.
  • May include additional fees, such as front-end loads, back-end loads, or 12b-1 marketing fees.

4. Tax Efficiency

• ETFs
  • Generally more tax-efficient due to the in-kind creation and redemption process.
  • This process minimizes capital gains distributions to shareholders.
• Mutual Funds
  • Less tax-efficient because fund managers may need to sell securities to meet redemptions, triggering taxable events.
  • Shareholders may incur capital gains taxes even if they did not sell their shares.

5. Minimum Investment Requirements

ETFs

• No minimum investment beyond the price of one share.
• Accessible to investors with smaller capital.

• Mutual Funds
  • Often have minimum investment requirements, which can range from $500 to several thousand dollars.

6. Liquidity

• ETFs
  • Highly liquid, with shares traded on exchanges throughout the day.
  • Market makers ensure availability for buying and selling.
• Mutual Funds
  • Less liquid, as transactions are processed once a day.
  • Not suited for frequent trading.

7. Transparency

• ETFs
  • Holdings are typically disclosed daily, providing investors with high transparency.
• Mutual Funds
  • Holdings are disclosed less frequently, often quarterly, which can limit transparency.

Key Considerations for Investors

• ETFs are ideal for cost-conscious investors who value transparency, tax efficiency, and flexibility. They suit both short-term traders and long-term investors.
• Mutual Funds may be better for those seeking active management or who prefer hands-off investing with automatic reinvestment options.

Check the ETF BASICS SERIES for further insights

What ETFs Mean for Investors

ETFs have transformed the way we invest, making it easy to access entire markets with just one trade. They offer a blend of stability and flexibility that suits both beginner investors and seasoned professionals. By understanding how ETFs are created and managed, you gain insight into the mechanics of your investments and the network of entities working to make these tools reliable and effective.

As Benjamin Graham once said,

“The individual investor should act consistently as an investor and not as a speculator.”

ETFs empower investors to follow this wisdom, allowing for consistent and diversified investing without the complexities of picking individual stocks.

So, next time you consider adding an ETF to your portfolio, you’ll know the story behind the ticker symbol. From the initial creation by authorized participants to the ongoing management and market support, ETFs are designed to offer you a balanced, efficient way to invest in the world around you. By knowing how they work, you’re one step closer to investing with confidence.