0

When a new index fund is created, how does it go from a concept to product?

Where does the money come from to buy the initial investments that are needed for the fund to have its advertised characteristics? Does the founder provide an initial investment? If so, how is the initial capitalization of the fund decided?

Adam Millerchip
  • 109
  • 2
  • 1
    Is there something in particular about index funds that you think would make funding the creation of them different than any other type of mutual fund, or for that matter different than starting up any business venture? – Ben Miller Aug 13 '20 at 10:24
  • Somewhat relevant: Understanding how an ETF works – Flux Aug 13 '20 at 11:00
  • 1
    @BenMiller-RememberMonica an index fund by definition tracks an index. I'm interested in the mechanics of how that it makes itself worth the index's value before it has any investors money with which to buy the underlying assets. A mutual fund and a business do not necessarily have to align their values to an index. Right now the S&P 500 index is at $3380. If the first investor invested $3380, I'm interested what the fund would have to do make sure that investment tracks the index. – Adam Millerchip Aug 13 '20 at 11:34
  • 3
    Some context: I was looking at a new fund that tracks a global index. It had a very small capitalization (because it's new), which made me wonder how funds get started up. Attempting to search for this mostly returned results about how to invest in a fund, not how the fund actually works, hence this question - and hopefully better search results for the next person. – Adam Millerchip Aug 13 '20 at 11:36
  • @AdamMillerchip "Right now the S&P 500 index is at $3380." No. It is at 3380 points. Whether an ETF share on this index is valued at $3.38, at $33.80, at $169 or whatever value is the decision of the founter of the ETF. – glglgl Aug 13 '20 at 12:02
  • Welcome new user. It's a great question! @AdamMillerchip , you should just state the fund you were looking at, it would be more specific and a better question. – Fattie Aug 13 '20 at 12:59
  • @Adam Millerchip: An index fund does try to track an index by periodically re-balancing. It is not directly tied to the index as there will be certain thresholds and delays in re-balancing, and a cash reserve to buffer new investments and withdrawal of old ones.

    So how do you start one? Announce it, wait for the first investors to send their money and start buying according to the index.

     – Daniel Aug 13 '20 at 13:10
  • @Fattie I think the fund information is only available in Japanese. It was the Nomura Three Zeros Developed Markets fund, which tracks the MSCI Kokusai (Developed ex Japan) index. Capitalization is about $1M. https://advance.quote.nomura.co.jp/meigara/nomura2/qsearch.exe?F=users/nomura/detail2&KEY1=01319203. But I'm really interested in the general concept rather than this fund specifically. – Adam Millerchip Aug 13 '20 at 14:07
  • right, its a good question @AdamMillerchip !! only $1m, how can it even work ?? – Fattie Aug 13 '20 at 14:40
  • It turns out it's a version of an existing, much bigger, fund for tax advantaged accounts that shares the same underlying investments. But that sort of demonstrates my question. Funds have to start somewhere, where is that? – Adam Millerchip Aug 13 '20 at 16:29

2 Answers2

1

I only can describe it roughly: The designer of the ETF defines the relation of the price of one share to the index value. E. g., they can define that at index 3380, the share is worth $33.80.

Then, one or more authorized participants can turn a basket of the respective company shares to a number of, say, 10,000 ETF shares and offer them for $338,000 plus a certain spread at an exchange. An investor can buy them there.

If the prices of the underlying securities change, the ETF price on the exchanges change as well due to the changed behaviour of the buyers and sellers.

glglgl
  • 5,417
  • 1
  • 17
  • 34
1

In the U.S. the ETF sponsor files with the SEC. If approved, the sponsor forms an agreement with an authorized participant who has the authority to create or redeem ETF shares.

The AP borrows shares, places them in a trust, and the trust provides the AP with ETF units. The ETF shares are then sold to the public on the stock exchange.

Bob Baerker
  • 76,304
  • 15
  • 99
  • 175