Pimco Bought Some Little Bonds

Say you run an S&P 500 exchange-traded fund. At the end of each day, you value all your stocks, apply the patented S&P 500 formula,1 and you get the value of your ETF; yesterday it was about $198. But hang on, you say. You know what's a great company? Apple. They make big phones, they're doing a watch, just crackerjack stuff. Right now the stock trades at about $102, but that just seems crazy to you; it's gotta be worth at least $150. So you adjust your books to reflect Apple's real value of $150, not the silly $102 that it's trading at. And since Apple is about 3.5 percent of the S&P 500, that adjustment adds about $3 to the value of your portfolio. So now your ETF is worth $201. You've just made a 1.5 percent extra return in a day. Your fund is great!

What stops you from doing this? Well it is boringly illegal,2 but on the other hand the Securities and Exchange Commission moves slowly, so you could do it for a while before the law catches up to you. What stops you quicker is that you're running an ETF. The way your ETF works is that anyone3 can come to you, hand you a big basket of the underlying stocks in the index and get back shares of your ETF (this is called "creation"). Or they can hand you shares of the ETF and get back the underlying stocks ("redemption"). If you're pricing Apple at $150 when it's trading at $102, then someone will go buy all the shares in the index, including Apple, for $198, hand them to you and get back shares of your ETF that you say are worth $201. Then they'll sell the shares of the ETF, make a profit and arbitrage the difference down to zero.4 So your claim that Apple is worth $150 in your portfolio has no effect. Apple is worth what the market says it is worth, and Apple in your portfolio is worth what the market says it's worth elsewhere.