Growing up, pasta was my favorite food. I would eat it nearly every night for dinner and—when my parents weren’t looking—my grandmother would let me have it for breakfast too. Only after I left for college did I realize how much money I was saving my parents by eating this carb-loaded diet (you can thank me later, Mom and Dad).
A simple pasta dish can cost you a whopping $2.98: spaghetti, $0.99; tomato sauce, $1.99. Technically it can cost you even less considering you usually don’t use the entire can of tomato sauce—or at least a broke college student doesn’t!
When the price of tomatoes goes up, the cost of your pasta dish will inevitably increase—much like the value of a pooled investment vehicle: When the value of the underlying securities increases, so should the value of the pooled security, whether a mutual fund or an ETF.
But recently I’ve received a number of questions about the impact that ETFs have on the value of their underlying holdings or, as in our more appetizing scenario, the impact of the pasta dish on the price of tomatoes; namely, do ETFs increase/decrease the prices of their underlying securities? This question is based on a number of misguided assumptions that attempt to distinguish a mutual fund from an ETF. Let’s walk through them together.
Make more, please?
Before we do, it is important to review the creation/redemption mechanism of ETFs (retire your forks for just a few moments). When the demand for a specific ETF increases to the point at which the ETF begins to trade at a significant premium, an institutional client known as an authorized participant (AP) will create new shares of the ETF to satisfy the market’s demand. To do so, the AP will typically buy the underlying holdings from the market and deliver them to the sponsor in return for new ETF shares. (The reverse will happen when an AP redeems ETF shares.)
And herein lies the question: Does the creation (redemption) process artificially increase (decrease) the value of the underlying holdings? Does the process of cooking (not cooking) a simple pasta dish increase (decrease) the cost of tomatoes?
Creating is not the same as buying
Vanguard’s research has found that more than 80% of all ETF transactions happen in the secondary market between investors like you and me. Remember how I pointed out that college students don’t typically use the entire can of tomato sauce every time they whip up a bowl of pasta? Similarly, there is no buying or selling of underlying securities. There is no creating or redeeming of ETF shares. Only when the ETF begins to trade at a significant premium or discount does the act of buying and selling the underlying securities kick into gear via the creation/redemption process.
To believe that these actions can materially influence the value of the underlying holdings, you would need to assume that ETF assets make up a major portion of the trillions of dollars in global markets. But since they represent a small fraction of the global markets, this simply is not the case.
Similarly, there is a much larger market for tomatoes than for my frugal pasta dish. One cannot assume that the cash flows into ETFs affect markets meaningfully differently from those into traditional mutual funds. As you can see in the chart below, using our S&P Small-Cap 600 ETF (VIOO) to illustrate this point, trading 40 times its average daily volume (ADV) in one day does not have a material impact on the underlying holdings even in the event of a creation. The largest percentage of ADV of the underlying top ten holdings amounted to a mere 2.13%.
You may be saying to yourself, But an ETF’s value and the value of its underlying securities should be highly correlated—after all, they are invested in the same holdings! Bingo. The structure of the creation/redemption process intends that the value of the ETF represent the value of the underlying holdings. Therefore, when the underlying assets change in price, the values of the underlying securities and the ETF should converge. The values of the underlying securities are affected by micro (company earnings, success of a new drug in an FDA trial, etc.) and macro (Federal Reserve policy, economic strength, etc.) events. ETFs invested in these underlying securities should expect to be affected by the same micro and macro events to a similar degree.
In summary, strong or weak flows into certain ETFs or categories do not inflate or deflate prices any more than mutual fund flows or the collective purchases of individual investors into stocks like Apple or Facebook. Rather, ETFs reflect the valuation of the underlying securities they are composed of, which is driven by the collective wisdom of all market participants. I hope you have found this piece as appetizing as the breakfast pasta dishes my grandmother prepared for me in my youth!
I would like to thank my colleague Shani Weiss for her contributions to this blog.
- All investing is subject to risk, including the possible loss of the money you invest.