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ETF Basic

How do ETFs work ?

Exchange-traded funds (ETFs) have gained popularity as accessible investment options. Understanding how ETFs work is vital for new investors. In this comprehensive guide, we’ll simplify and explore the construction of ETFs in the Vietnamese market, covering their overview, functionality, pricing, and determinants of liquidity.

How-do-ETFs-work-Understand-the-Creation-Redemption VN
How-do-ETFs-work-Understand-the-Creation-Redemption VN

1. Overview of ETF 

  • Most ETFs operate based on a reference index, such as a stock, commodity, or bond index. The primary goal is to replicate the performance of the chosen index by adjusting their portfolios to match changes in the index composition.
  • In Vietnam, ETFs are traded on the stock market, allowing investors to buy and sell ETF shares like individual stocks. These ETFs closely track the Net Asset Value (NAV) during trading sessions, providing transparency to investors. 
  • ETFs are investment funds that hold a diversified portfolio of assets, including stocks. The ETF’s performance is directly linked to the performance of the underlying assets.
  • Benefits of Investing in ETFs:
    • Diversification: ETFs provide instant diversification as they typically hold a basket of different securities.
    • Liquidity: Being traded on stock exchanges, ETFs offer liquidity, allowing investors to buy or sell shares during market hours.
    • Transparency: ETFs disclose their holdings daily, providing transparency to investors about the fund’s assets.
    • Low Costs: ETFs often have lower expense ratios compared to traditional mutual funds, making them cost-effective for investors.
    • Flexibility: ETFs are traded on the stock market, allowing investors to buy and sell ETF shares like individual stocks including long-term investing, short-term trading, and asset allocation.

Learn more about  what is ETF>>>

2. How do ETFs work?

  • In the Vietnam primary market, ETFs do not directly sell individual shares to investors. Instead, they issue shares in large creation units.
  • According to VSDC, a creation unit consists of a minimum of 100,000 ETF shares. Investors acquire these units not with cash but through a portfolio of structured securities mimicking the approved index’s composition. This primary market trading often involves Authorized Participants (APs), market markers and Fund Managers.
  • Investors or APs can break down these creation units and sell individual ETF shares on the secondary market. This allows other investors to buy individual units rather than large lots in the primary market. After purchasing creation units, investors or AP could break them down and sell individual ETF shares on the secondary market.
  • Trading Options for Investors: Investors looking to sell ETF shares have two choices:
  1. 1. They can choose to sell individual shares to other investors on the secondary market
  2. 2.  ETF redeems creation units by swapping a Portfolio composition file (PCF) to get the ETF creation units. 

>> Learn more about Creation and Redemtion

3. Pricing of an ETF share

Below are some key points about how ETFs are priced and the arbitrage mechanism.

  • Net Asset Value – NAV
      • The NAV of an ETF is calculated based on the market value of securities in the structural portfolio, after deducting operating fees.
      • NAV is calculated daily by the fund management company and confirmed by the custodian bank.
      • The fund manager calculates and publishes the Net Asset Value (NAV) of the ETF daily based on the closing prices of securities in the portfolio, adjusted for fees and expenses.
  • Differential Price and Market Price
    • In trading sessions, the market price of ETF shares could fluctuate due to stock price fluctuation and demand from trading securities. The variance between the market price and Net Asset Value (NAV) generates an arbitrage trading opportunity.
  • Arbitrage Activity: The arbitrage activity in ETFs in Vietnam, the arbitrage plays a crucial role in maintaining the alignment between the market price of ETF shares and their Net Asset Value (NAV). This mechanism involves the participation of Authorized Participants (APs) and ensures that ETFs trade at prices that closely reflect the value of their underlying assets

1. When ETF Price is Higher Than NAV

      • Situation: If the ETF’s price is more than its (NAV), it creates an opportunity.
      • Action: Arbitrage participants can buy individual stocks from the ETF’s portfolio, swap them for ETF units, and then sell those units in the stock market for a profit.

2. When ETF Price is Lower Than NAV:

    • Situation: If the ETF’s price is less than its actual value (NAV), it’s another chance.
    • Action: Arbitrage participants could purchase ETF units on the securities market, swap them for the underlying structured securities, and then sell these individual securities separately in the market to gain profits.

3. Maintaining ETF Price Consistency: The buying and selling activities happening among fund members and market, APS ensure that the price of ETF closely aligns with the individual stocks inside the ETF.

4. Determinants of ETF Liquidity:

ETF liquidity is influenced by factors such as the investment portfolio, trading volume of securities, ETF share trading volume, and the overall investment environment. Higher liquidity is designed to be a characteristic of ETFs compared to traditional mutual funds.

  • 1. The ETF’s investment portfolio: Primary factor

The most significant factor influencing ETF liquidity. If invested assets are freely traded, ETF shares will also trade more smoothly. If ETF tracks or invests in large-cap stocks listed on the stock market often have higher liquidity, providing investors with increased ease of buying or selling shares.

  • 2. Trading Volume of Securities: Where Supply Meets Demand

Securities’ trading volume is a direct result of supply and demand. Securities with lower risk are typically more attractive to traders, leading to higher trading volumes. Therefore, ETFs investing in frequently traded stocks tend to have higher liquidity. 

  • 3. ETF Share Trading Volume: Investors in the Spotlight

The number of investors interested in ETF shares directly impacts ETF’s liquidity. Increased willingness to trade contributes to higher volume, consequently boosting liquidity.

  • 4. Investment Environment: Navigating Risk Dynamics 
  • The risk level of the investment environment plays a pivotal role in shaping ETF liquidity. ETFs that track or invest in high-risk industries or operate during economic downturns or market fluctuations may find it difficult to attract investors directly, impacting the liquidity of the ETF. Investors tend to approach high-risk sectors with caution, impacting the demand for ETF trading. This cautious approach may lead to reduced trading activities, influencing the liquidity of ETFs.
Understanding “How do ETFs work” is crucial for any investor navigating the Vietnamese market. Whether you’re a seasoned professional or a newcomer to investing, this information may empower you to make informed investment decisions. Always stay updated with the latest stories and market insights to navigate your investment journey wisely. Happy investing with KIS Vietnam ETF! For in-depth insights into ETFs or to address any queries, feel free to reach out to KIS Vietnam.
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