ETFs trade on the ASX like shares, yet they always trade very close to the value of their underlying assets. This doesn’t happen by accident — a mechanism called the creation and redemption process keeps ETF prices in line with their net asset value (NAV). Understanding how ETFs work helps you invest in them with confidence.
ETF Pricing — NAV and Market Price
The Net Asset Value (NAV) of an ETF is the total value of all underlying assets divided by the number of units on issue.
$$\text{NAV per unit} = \frac{\text{Total value of holdings} - \text{Liabilities}}{\text{Units on issue}}$$
Example:
- VAS holds $12 billion in ASX shares
- 500 million units on issue
- NAV = $12,000,000,000 ÷ 500,000,000 = $24.00 per unit
If VAS trades at $24.05 (a $0.05 premium to NAV), an arbitrage opportunity exists. This is where market makers come in.
Market Makers and Arbitrage
ETF issuers (like Vanguard and BetaShares) contract with market makers — financial institutions that continuously quote buy and sell prices for the ETF on the ASX. Market makers keep the ETF price aligned with NAV through arbitrage:
If ETF trades at a premium to NAV:
- Market maker creates new ETF units (delivering underlying shares to the ETF issuer)
- Sells the new units on the ASX at the (higher) market price
- Profit = premium to NAV
- Additional supply drives market price back down toward NAV
If ETF trades at a discount to NAV:
- Market maker buys cheap ETF units on the ASX
- Redeems them with the ETF issuer (receiving the underlying shares)
- Sells shares at market value
- Profit = discount to NAV
- Reduced supply drives market price back up toward NAV
This mechanism means ETF prices almost never drift significantly from their underlying NAV — unlike Listed Investment Companies (LICs), which can trade at persistent discounts.
The Creation and Redemption Process
The creation/redemption process is unique to ETFs and is why they differ fundamentally from managed funds and LICs:
Unit creation:
- Authorised participant (large institutional firm) delivers a basket of underlying securities to the ETF issuer
- ETF issuer creates new units and gives them to the participant
- Participant sells units on the ASX or uses them to close a short position
- More units in circulation → downward price pressure → NAV alignment
Unit redemption:
- Authorised participant delivers ETF units to the issuer
- ETF issuer redeems units and returns the underlying securities basket
- Fewer units in circulation → upward price pressure → NAV alignment
How ETFs Track Their Index
Most Australian ETFs use full replication — buying every security in the index they track, in the same proportions.
Example — VAS tracking the S&P/ASX 300:
- The ASX 300 has 300 securities
- VAS buys all 300 in their index weights
- When CBA represents 9% of the ASX 300, VAS holds approximately 9% in CBA
Some ETFs use sampling — particularly for large international indices with thousands of securities. The ETF buys a representative sample that closely mirrors the index’s characteristics without holding every security.
Tracking Error and Tracking Difference
Tracking error — the standard deviation of the difference between ETF returns and index returns over time. Lower is better.
Tracking difference — the actual cumulative difference between ETF return and index return over a period. This is the most practical measure of how well the ETF replicates its index.
Tracking difference is caused by:
- Management fees (MER)
- Transaction costs when rebalancing
- Dividend withholding tax on international holdings
- Cash drag (uninvested dividends held temporarily)
Physical vs Synthetic ETFs
Physical ETF — the fund actually buys the underlying assets. Most Australian ETFs are physical. Lower counterparty risk.
Synthetic ETF — uses derivatives (swaps) to replicate index returns without holding the underlying assets. More common in some international markets. Adds counterparty risk.
Most Australian retail investors hold physical ETFs.
ETF Tax Efficiency
ETFs are generally more tax-efficient than managed funds because:
- The in-kind creation/redemption process means the ETF rarely needs to sell securities to meet redemptions (triggering CGT events)
- Index funds have lower portfolio turnover than active funds — fewer taxable events each year
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Frequently Asked Questions
Why is the ETF price sometimes slightly different from its NAV? A small difference (a few cents) between market price and NAV is normal during trading hours — the NAV is typically calculated once daily at market close using official closing prices, while the ETF trades throughout the day. Market makers keep this difference very small (usually under 0.1% for liquid ETFs). On illiquid or exotic ETFs, this spread can be wider.
What happens to my ETF if the fund manager (e.g., Vanguard) goes bankrupt? ETF assets are held separately from the fund manager’s own assets — your investment is protected in a trust structure. If Vanguard Australia ceased operations, the fund’s assets (your underlying shares) would be transferred to another manager or returned to investors. The ETF structure provides strong investor protection compared to depositing money directly with a company.
Does an ETF’s unit price per unit matter? Not fundamentally. Whether VAS trades at $90 per unit or DHHF at $35 per unit does not make one “cheaper” — what matters is the total value of your investment and the MER. You buy the number of units that equals your desired investment amount, regardless of price per unit.
This article provides general financial information only. For advice tailored to your situation, speak with a licensed financial adviser. You can find one through the ASIC financial advisers register or MoneySmart.