An ETF is easy to understand. The structure is designed to give brokerage account access to a diversified basket of stocks, bonds or other asset types. While structural similarities exist between ETFs and individual issues, there remain differences that require understanding to ensure their effective use, which includes buying and selling for both longer-term and shorter-term strategies.
Those who make markets in stocks solely react to supply and demand for a given stock. They stand between buyers and sellers, and use their own inventory to reconcile the time—and sometimes price—differences.
ETFs have an elastic supply of shares. That is, certain market participants can create (new shares that enter the market) or redeem (shares extinguished) ETF shares. Thus, ETFs are derivatives—traded instruments that derive their value from other instruments, although unlike traditional derivatives, ETF shareholders actually own a pro-rata share of the fund’s underlying securities.
Given these facts, it is of the utmost importance that ETF market makers (MMs) know the holdings of an ETF, and by extension, an ETF’s value throughout the trading day. This is not only important for MMs’ own profit and loss, but also so they can better manage their risk, which makes more efficient markets for advisors and individuals to trade.