Exchange traded funds as a CFD market

A fund and a listed security at the same time 

An exchange traded fund is two things held together in one structure. It is a fund, meaning a pool of assets held by a manager on behalf of everyone with a claim on it, and it is a listed security, meaning that a claim on that pool has been split into shares which are admitted to trading on a stock exchange and change hands between investors all session long. A traditional mutual fund only has the first half of that description: an investor deals with the fund itself, once a day, at a value struck after the market closes. An exchange traded fund adds a secondary market, so the shares trade between buyers and sellers at whatever price the two agree, at any moment the exchange is open.

Nearly every distinctive feature of the class comes out of that pairing. The fund half explains what the price is anchored to, because the shares represent a slice of a real portfolio of shares, bonds, metal or futures. The listed half explains why the price moves continuously, why it has a bid and an offer, why it can gap at the opening auction, and why it can sit slightly above or below the value of the portfolio underneath it. Most questions about exchange traded funds resolve into a question about which half is being talked about.

The two prices, and the distance between them 

Every exchange traded fund carries two numbers that describe what one share is worth. The first is net asset value: the market value of everything the fund holds, less anything it owes, divided by the number of shares in issue. It is calculated by the fund administrator, published once a day after the close for most funds, and estimated through the session for many of them. The second is the market price: whatever the last buyer and seller on the exchange agreed on. Net asset value is an accounting statement about the portfolio. The market price is a fact about supply and demand in the fund's own shares.

The gap between the two is called a premium when the market price is higher and a discount when it is lower, and for the largest funds on the most liquid portfolios it is usually very small. It is kept small by a mechanism rather than by a rule: specialist firms can exchange baskets of the underlying securities for new fund shares, or hand fund shares back for the securities, which makes a persistent gap an arbitrage that those firms have an interest in closing. The gap widens when that mechanism is obstructed, most commonly when the market for the holdings is closed, thin or moving fast.

What the class contains 

Exchange traded funds are a wrapper, not an asset, so the class spans several markets rather than one. Broad equity index funds hold the constituents of a published index, as the SPDR S&P 500 ETF, the Vanguard S&P 500 ETF, the Vanguard Total Market fund and the Invesco QQQ Trust do. Sector funds narrow the same idea to one slice of the market, which is what the Technology Select Sector, Financial Select Sector and Energy Select Sector funds hold. Bond funds hold fixed income, from long dated government paper in the iShares 20+ Year Treasury fund to corporate credit in the iShares Investment Grade and High Yield funds. Commodity funds hold metal in a vault, as SPDR Gold Shares and the iShares Silver Trust do, or futures contracts, as the United States Oil Fund does. Regional funds hold a foreign market, as the iShares MSCI Japan, iShares MSCI Emerging Markets and iShares China Large-Cap funds do.

The practical consequence is that no single statement about drivers, volatility or trading hours holds across the whole class. A fund holding long dated government bonds and a fund holding semiconductor shares are the same legal wrapper around portfolios with almost nothing in common. Anything specific has to be read off the fund's stated objective and its holdings, which every issuer publishes.

Who trades them 

Four groups meet in the order book, and they are there for different reasons. Long term allocators, including pension schemes, insurers and index funds of funds, use the largest broad market funds as a way of holding an entire market in one line. Active managers use sector and regional funds to adjust exposure quickly without dealing in dozens of individual names. Market makers quote both sides of the order book continuously and manage the resulting inventory against the underlying basket. Short horizon traders, including retail participants, trade the most liquid funds because a single instrument carries the movement of a whole index or sector.

A fifth participant sits outside the order book but shapes it. Authorised participants, which are large broker dealers under an agreement with the issuer, are the only firms that can create and redeem fund shares directly with the fund. Their activity is what ties the exchange price back to the portfolio, and it is the reason the market price of a large fund tracks its holdings closely without anyone administering that outcome.

When they trade 

A fund's shares trade during the hours of the exchange that lists them, and the great majority of the funds a CFD is commonly written on are listed in the United States, so their session runs from the opening auction to the closing auction of the American equity day, with pre and post market sessions that are thinner. That schedule belongs to the listing venue, not to the holdings, and the two can diverge sharply. A fund holding Japanese shares trades in New York while Tokyo is closed, so its price through the American session reflects expectations about where the Japanese market will open rather than transactions in those shares.

Liquidity within the session is uneven in the ordinary way. The opening auction sets the first price after a long gap in trading and the closing auction concentrates a large share of the day's volume. Bid offer spreads on the fund tend to be widest at the opening, when the value of the portfolio is least certain, and tightest when the underlying market is trading freely alongside it.

How a contract for difference on an ETF settles 

A contract for difference written on an exchange traded fund references the fund's listed price and settles the change in it, in cash. No fund shares are bought, nothing is registered in anyone's name, and no claim on the portfolio is created. The contract has a size stated as a number of fund shares, and the result is the difference between the closing and opening price multiplied by that number. Because the contract references a listed price rather than net asset value, every premium and discount described above passes straight into it: the contract settles the price the market made, including any deviation from the portfolio's value.

Two adjustments follow from the fund being a fund. Most equity and bond funds distribute the income their holdings generate, and on the ex distribution date the fund's price steps down by roughly the distribution; brokers conventionally apply an adjustment to open positions so that the step does not create an artificial result. Separately, a position held past the daily cut off carries a financing adjustment for as long as it stays open, because the full contract value was never funded.

What the contract does not carry is everything that comes with owning the fund's shares: no voting at fund level, no entitlement to the portfolio, no ability to redeem, and no transfer of the position to another firm, because the contract exists only between the two parties who wrote it. The costs charged inside the fund still reach the contract indirectly, since the fund's expense accrual is one of the things that shapes the price the contract references.