How an ETF is built

The wrapper the fund lives in 

An exchange traded fund begins as a legal container. An issuer registers a fund, states its investment objective in a prospectus, appoints a manager to run the portfolio, appoints a custodian to hold the assets separately from the manager's own balance sheet, appoints an administrator to value the portfolio each day, and applies to list the fund's shares on an exchange. The container matters because it determines what the fund is allowed to hold and what a shareholder actually owns. Most equity and bond funds are open ended investment companies or unit trusts, which can issue and cancel shares continuously. Several commodity funds are structured as grantor trusts holding one physical asset, and some futures based funds are structured as commodity pools, which is a different legal form again.

A fund that tracks a published index adds one more relationship: a licence from the index provider. The index is intellectual property, the provider defines and maintains its rules, and the fund pays to use it and to receive the constituent file. That is why several competing funds can track the same index and why an index change made by the provider propagates into every fund licensed to follow it, on the date the provider specifies rather than on a date the fund chooses.

Creation and redemption, in blocks 

Ordinary investors never deal with the fund itself. They buy and sell existing shares from other investors on the exchange, which changes who holds the shares but changes nothing about the fund. The supply of shares is adjusted through a separate channel, open only to a small set of large broker dealers that have signed an agreement with the issuer. Those firms are called authorised participants, and they deal with the fund in blocks known as creation units, each a fixed and large number of fund shares.

Creation runs in one direction and redemption in the other. To create, an authorised participant assembles a basket of securities matching the fund's published creation basket for that day, delivers it to the fund, and receives one creation unit of new fund shares in exchange. To redeem, the participant delivers a creation unit of fund shares back and receives the basket of securities. The exchange is in kind, meaning securities are swapped for shares rather than either side paying cash, though funds holding assets that are awkward to deliver, including many bond and futures based funds, use cash or a mixture instead. The number of shares in issue therefore expands and contracts with demand, which is why a fund's size can grow without its price being pushed up by the buying.

The arbitrage that anchors the price 

The creation channel exists for a structural reason rather than an administrative one. It converts any gap between the fund's market price and the value of its holdings into a trade an authorised participant has an economic interest in making, and that interest is what keeps the two numbers close without anybody enforcing it.

When persistent buying pushes the fund's shares above the value of the basket, a participant can buy the basket in the open market, deliver it, receive new fund shares and sell them at the higher price. That selling presses the fund's price back down and the buying lifts the basket, so the two converge. When selling pushes the fund's shares below the basket, the same firm runs the trade in reverse: buy the cheap fund shares, redeem them for the basket, sell the basket. Neither leg is a favour to the market. Each is a spread the firm captures, and it is available only while the gap is wider than the cost of doing it.

How the portfolio itself is held 

A fund tracking a small, liquid index can hold every constituent in its exact index weight, which is called full replication. A fund tracking an index with thousands of constituents, or one containing securities that are expensive or restricted to trade, holds a representative subset chosen so the subset's characteristics match the index, which is called sampling or optimisation. Sampling is why two funds following the same index can post slightly different returns even before their fees are compared. A third approach holds no constituents at all and obtains the index return through a swap with a bank, which removes one source of divergence and introduces exposure to the bank instead.

The portfolio does not stand still. Index providers review constituents on a published calendar, adding and removing names and resetting weights, and the fund follows those changes so that it continues to hold what the index describes. Corporate actions in the holdings, including splits, mergers and distributions, are processed inside the fund. Many funds also lend a portion of their securities to other market participants against collateral, returning some of the resulting revenue to the fund, which offsets a part of its costs and introduces a counterparty relationship that the prospectus describes.

What the fund costs itself 

A fund charges its own management fee, and it is never invoiced to a shareholder. It accrues daily inside the portfolio, which lowers net asset value fractionally each day and therefore lowers the price the fund's shares trade around. That is the mechanical reason a tracking fund tends to return slightly less than the index it follows over a long period, before any other source of divergence is considered. Trading costs inside the fund, withholding tax on foreign income and the drag of holding a small cash balance work in the same direction, while securities lending revenue works against it.

What a contract for difference inherits from all this 

A contract for difference written on a fund takes part in none of this machinery. No creation unit is assembled, nothing is delivered in kind, and no shareholding exists to be redeemed. The contract references the fund's listed price and settles the change in it in cash, which means it inherits the output of the machinery without any of its rights. The expense accrual, the sampling decisions, the index reviews and any premium or discount left standing by the arbitrage all reach the contract through the one channel that matters to it, which is the price on the exchange.