A feature of Exchange Traded Funds (ETF) that gets a lot of attention is their ability to trade throughout the day. While that is similar to stocks, there are important differences that should be understood. One Major difference is in supply.
Stocks typically have a set amount of shares available to the public – their supply is fixed. When more and more investors demand to buy the shares of that stock that has a finite supply, the price of that stock will increase. Economics 101.
The supply of an ETF is not finite, the number of shares available can adjust to demand. As demand for the ETF rises, supply can be increased, and vice versa. This unique feature allows the market price of the ETF at which investors can buy and sell to remain in line with the true value of the fund given sufficient liquidity.
It’s important to note, an ETF is basket of securities and the price of an ETF is based on the underlying securities in that basket, not necessarily the demand for the ETF itself. The securities in the basket drive the price of the fund and also liquidity – which is a topic for a separate post.