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How the Pricing of an ETF Works - Basics of Stock Market Investing (WHAT DETERMINES ETF SHARE PRICE) - YouTube
Channel: fu academy
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Whoa, okay! So, ETFs have become so so聽
popular over the last few years because聽聽
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they come with some really nice benefits, such聽
as diversification, low costs, high liquidity,聽聽
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it's easily accessible and it's super聽
transparent. But if you are the average investor,聽聽
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they can be a bit of a mystery. You aren't聽
exactly sure how they work and why the share聽聽
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price between ETFs is so different. Well, today聽
is the day to find it out. So, let's get it!聽聽
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What's up everyone?! This is fu academy -聽
your channel for financial education. And on聽聽
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this channel, I share lifestyle, investing-style聽
and educational videos, just like this one. So,聽聽
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if you are new here, consider SUBSCRIBING! This聽
is part 2 of my "Mini ETF Series". Part 1 explains聽聽
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the concept of ETFs and their pros and cons. Check聽
out the video in the link if you haven't already聽聽
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watched it. An ETF is an exchange traded fund. It聽
makes more sense if we read it backwards: So, it's聽聽
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a "fund" that is "traded" on a stock "exchange".聽
So, let's first look at how a fund works.聽聽
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Imagine you get together with 2 other friends.聽
Everyone invests 10,000 dollars. You put all聽聽
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that money in a basket. So, you have 30,000聽
dollars in total. With those 30,000 dollars,聽聽
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you buy a selection of stocks. The basket聽
that you have is nothing else than a fund.聽聽
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And to make it fair, everyone gets the same聽
amount of shares in this fund, because remember:聽聽
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Everyone invested the same 10,000 dollars. Let's聽
say everyone gets 10 shares. This makes a total of聽聽
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30 shares. So, in the basket, we have 30,000聽
dollars divided by 30 shares. It means that聽聽
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each share is worth 1,000 dollars. Let's assume聽
that the stocks in your fund are now performing聽聽
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really well. Some go up by 5% and others go up by聽
15%. But on average, the stocks increased by 10%.聽聽
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So, the total investment amount of 30,000聽
dollars has increased to 33,000 dollars. Now,聽聽
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every share is not worth 1,000 dollar anymore,聽
but 1,100. Now, let's assume that 1 person out聽聽
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of the 3 of you wants to get out of the fund and聽
she wants her money back. Now, you have 2 options.聽聽
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Option 1 is that you buy the shares directly聽
of the person who wants to leave. In this case,聽聽
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she would get her 11,000 dollars and walk off.聽
The 10 shares of the person who just left will聽聽
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then be split amongst the 2 people that are聽
still in the fund. This means that the 2聽聽
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remaining people in the fund get 5 additional聽
shares each. This will increase the total聽聽
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number of shares per person to 15 with a value聽
of 16,500 dollars each. So, this was option 1.聽聽
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Option 2 is that you sell the shares of the person聽
that wants to leave the fund for 11,000 dollars聽聽
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and give that money directly to this person. In聽
this second scenario, nothing changes for the 2聽聽
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people that are still in the fund. Both still have聽
10 shares with a value of 11,000 dollars each. So,聽聽
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understanding this example will really help you聽
to understand the pricing mechanism of ETFs. Now,聽聽
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let's look at the ETF share price. There can be聽
different ETF providers that track the same index聽聽
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like the S&P 500. Now you might ask yourself why聽
they all have different share prices when they聽聽
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track the same thing. To answer this question,聽
we need to look at how the price of an ETF is聽聽
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calculated. To get to the price of 1 ETF share,聽
you need to take the value of all stocks included聽聽
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in the ETF and divide those by all ETF shares out聽
there. Let's actually look at an example and do聽聽
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that together for the iShares Core MSCI World聽
ETF. If you Google "Core MSCI World iShares",聽聽
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it will bring you directly to the iShares website.聽
You could first see the name and the price per ETF聽聽
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share for this ETF. If you scroll down, you can聽
have a look at the historical chart performance.聽聽
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Let's look at the last 5 years here and you can聽
see that despite the crash of 2020, your portfolio聽聽
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would have grown over that time. Let's move聽
on to the key facts section. Here, you can see聽聽
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the net asset value of the fund, which currently聽
is 25.5 billion dollars. If you scroll down more,聽聽
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you will find the number of shares outstanding,聽
which currently stands at 388 million. If you then聽聽
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divide the 25.5 billion dollars in net asset聽
value by the 388 million shares outstanding,聽聽
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you will get to the current ETF share price of聽
65.7 dollars. Now, you might get a feeling why聽聽
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different ETFs that track the same index can聽
have a different share price. That's because聽聽
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each ETF has a different fund size - so the amount聽
it invests into companies - and a different number聽聽
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of ETF shares outstanding. But at the end of the聽
day, it really doesn't matter if an ETF costs聽聽
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10 or 50 dollars per share. What matters is聽
the price change, so if it goes up by 10%聽聽
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or down by 10%. Now you might think: "Hold聽
on! ETFs are traded on the stock exchange.聽聽
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And if they are traded on the stock exchange, then聽
their share price should be driven by supply and聽聽
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demand!" And that is correct! On the one side, an聽
ETF tracks the price movement of an index. And on聽聽
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the other side, the ETF share price is driven by聽
supply and demand. We are about halfway through!聽聽
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If you're getting value in this video, let me know聽
by hitting that LIKE button! Thank you so much.聽聽
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To understand the relation between the two, we聽
need to look at the creation and redemption logic.聽聽
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Let's say you want to buy an ETF share. So,聽
you log into your trading app and you buy聽聽
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this 1 share. Your order will then go through the聽
stock exchange to a so-called market maker. This聽聽
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market maker will check if there is a seller out聽
there that can be matched with your buying order.聽聽
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If that's the case, then you will receive the聽
ETF shares that another person wants to sell.聽聽
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This interaction happens on the so-called聽
secondary market. In this secondary market,聽聽
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ETF shares exchange ownership, but no new聽
ETF share is being created in that process.聽聽
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Now, it could be the case though that the demand聽
for a specific ETF is so high that there are more聽聽
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buying orders than selling orders. To avoid a聽
situation where a buying order cannot be executed聽聽
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anymore because the market maker is left without聽
ETF shares, there are authorised participants. I'm聽聽
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going to call them APs. these APs are in direct聽
contact with the ETF providers and they can聽聽
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create new ETF shares. APs usually work for bigger聽
banks. But what does an AP do now? They receive a聽聽
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buying list from the ETF provider. That's a list聽
of all the stocks that the ETF provider wants.聽聽
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The AP then goes out and buys these stocks. These聽
stocks are then handed over to the ETF provider聽聽
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and in return the ETF provider gives the AP newly聽
created ETF shares. The AP then gives those newly聽聽
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created ETF shares to the market maker, so to聽
the stock exchange. And the whole game continues.聽聽
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This process of creating new ETF shares is聽
called "creation" - makes sense. Redemption聽聽
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is the opposite of this. This happens when聽
there are too many ETF shares in the market.聽聽
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That's the case when there are more people聽
that want to sell an ETF share then there聽聽
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are people willing to buy the same share. In聽
this case, the AP can buy those ETF shares聽聽
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and give them to the ETF provider. In return,聽
the ETF provider will give the AP the stocks聽聽
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of the companies included in the ETF. The ETF聽
shares will be eliminated in this process. Now,聽聽
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the AP can sell these stocks in the market. This聽
whole game of creation and redemption is happening聽聽
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in the primary market, in which ETF shares are聽
being created and destroyed. Okay, we understand聽聽
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that. But how can the ETF share price be driven聽
by supply and demand and still track an index?聽聽
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This happens through the interaction聽
between primary and secondary market.聽聽
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So, the price of an ETF gets determined by聽
supply and demand on the secondary market. Now,聽聽
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the AP can use arbitrage to make a profit from聽
this. Let's look at an example to illustrate this.聽聽
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Let's say that the demand for a specific ETF is so聽
high that the price of this ETF increased a lot.聽聽
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Now, the ETF share is worth more than the聽
stocks of the companies that it holds. If聽聽
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that's the case, then the AP does the following:聽
He buys the cheaper companies that are included in聽聽
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that specific ETF and hands them over to the ETF聽
provider in exchange for newly created ETF shares.聽聽
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The AP will then sell those new ETF shares in聽
the secondary market for a small profit. Now,聽聽
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let's take a look at what happened here. So,聽
the AP bought the shares of the companies that聽聽
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are included in the ETF. By doing that, the聽
AP increased the demand for those shares.聽聽
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Increased demand for a specific product聽
leads to a higher price. At the same time,聽聽
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new ETF shares were created, which means that聽
the supply of the ETF shares has increased.聽聽
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If everything else remains the same, increasing聽
the number of shares will reduce the price of the聽聽
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ETF. This constant interaction has the effect聽
that the share price of the stocks and the ETF聽聽
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share price are constantly being balanced out.聽
Now, this all sounds super complicated - and聽聽
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it really is. But this process of creation and聽
redemption makes sure that ETFs can offer so聽聽
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many of the advantages that we love about them.聽
The most important one is: It keeps the costs low.聽聽
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And that's because this whole process between聽
AP and ETF provider is tax efficient. The聽聽
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stocks are not bought and sold between the聽
2 parties - they are only being exchanged!聽聽
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Stocks of companies against the shares of聽
the ETF. And that saves both parties a lot聽聽
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of capital gain taxes. This exchange between聽
stocks and ETF shares brings another advantage:聽聽
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The ETF provider doesn't have to set aside a huge聽
amount of cash, like active funds for example.聽聽
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Because the selection of the stocks that it tries聽
to track are not bought and sold - they are being聽聽
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exchanged. Parking cash can be very expensive聽
because interest rates that you get on this聽聽
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are close to 0%. And that brings down the聽
total returns of active funds. The cost of聽聽
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running a fund are included in the TER, the total聽
expense ratio. This is also why ETF funds have an聽聽
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average TER of around 0.16% and why active聽
funds have an average TER of 0.78%. So,聽聽
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there you have it: The pricing of ETFs. The聽
most important takeaways are... Number 1:聽聽
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The price of an ETF is calculated by taking聽
the value of all stocks included in the ETF and聽聽
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dividing it by the numbers of shares. Number 2:聽
On the stock exchange, so on the secondary market,聽聽
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buying and selling orders meet. No ETF shares聽
are being created or eliminated. Number 3:聽聽
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APs create new or eliminate existing shares聽
in the interaction with the ETF provider.聽聽
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Number 4: APs take advantage of the price聽
differences between the stocks that are聽聽
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included in an ETF and the value of the ETF聽
shares. Doing that, the AP balances out the聽聽
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price differences between the two. So, I hope聽
that this video could help you to understand聽聽
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how the pricing of ETFs work. This is actually聽
one of my first videos. So, if you want to support聽聽
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this channel, then please make sure you SUBSCRIBE!聽
So, thank you very much for doing that and peace!
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