Who Makes Money When You Buy an ETF?

Direct answer: When you buy an ETF on the secondary market, revenue flows to: your broker (through order routing, spread on order execution, or account fees), the market maker quoting the ETF (through the bid-ask spread), the exchange where the trade executes (transaction fee), and the clearinghouse settling the trade (clearing fee). The ETF manager receives no direct payment from this secondary market transaction; their revenue comes from the ongoing expense ratio on AUM.

Two markets, two sets of parties

To understand who earns from an ETF buy transaction, it helps to distinguish between the primary market and the secondary market for ETF shares. Most retail investors interact entirely with the secondary market: buying and selling shares on a stock exchange just as they would a share of common stock. The primary market, where authorized participants interact directly with the ETF manager to create or redeem shares in large blocks, is a separate process.

When you buy ETF shares through your brokerage account, you are almost certainly operating in the secondary market. You are purchasing shares from another market participant, a market maker, another investor, or an authorized participant, not directly from the fund. The fund itself is not a party to your transaction.

Your broker

The broker through which you place the order earns in several possible ways. In the U.S. retail market, brokers that offer zero-commission ETF trading typically earn through:

• Payment for order flow (PFOF): The broker routes your order to a specific market maker that pays a small fee per share or per notional dollar of the order for the right to execute it. The market maker earns from the spread; the broker earns the PFOF payment.
• Net interest income: Cash in your brokerage account earns interest in a sweep program. The broker pays you a portion and retains the rest. The larger your cash balance and the longer it sits uninvested, the more the broker earns.
• Margin lending: If you buy on margin, you borrow from the broker at an interest rate higher than the broker's cost of funds. The spread is profit.
• Securities lending: If you hold shares in a margin account, the broker may lend those shares to short sellers, earning a fee that may or may not be shared with you.

Brokers that have pledged to not accept PFOF still earn from the other mechanisms above. The ETF trade itself may be zero-commission, but it is rarely zero-revenue for the broker.

The market maker

When you place a buy order for an ETF, you pay the ask price, the price at which a market maker is willing to sell. The market maker simultaneously holds (or acquires) shares at a lower bid price. The difference, the bid-ask spread, is the market maker's gross revenue from the transaction.

For a liquid large-cap equity ETF like SPY (SPDR S&P 500 ETF), the spread at any given moment may be one or two cents per share, representing a very small cost as a percentage of the share price. For a smaller, less liquid ETF with lower daily volume, the spread may be five, ten, or even fifty cents per share, representing a much higher percentage cost.

The market maker also hedges the risk of holding ETF inventory. A market maker who sells you SPY shares and holds a net long position will often simultaneously short the underlying S&P 500 futures or buy/sell a basket of the underlying stocks to offset the price risk. The cost of this hedging is embedded in the spread they quote.

The exchange

Stock exchanges charge fees for executing trades on their platforms. The fee structure varies by exchange and order type. Exchanges often use a maker-taker model: they pay a rebate to market makers who post limit orders (providing liquidity) and charge a taker fee to market orders that remove liquidity. The net revenue to the exchange is the difference between what it charges takers and pays makers.

For a retail market order that executes via PFOF off-exchange (through a market maker's internal systems rather than on a public exchange), no exchange fee is charged. The transaction executes as an OTC transaction. This is one reason market makers prefer internalized PFOF flow: they avoid exchange fees while still capturing the spread.

The clearinghouse

After your ETF purchase executes, it must be cleared and settled. In the U.S., the DTCC (Depository Trust and Clearing Corporation), through its subsidiaries the NSCC (National Securities Clearing Corporation) and DTCC (for custody), processes the settlement. The NSCC nets trades across all its member firms, dramatically reducing the amount of cash and securities that need to change hands. It charges clearing fees for this service.

Settlement in U.S. equities occurs on T+1 (one business day after the trade date) as of May 2024. During the day between trade and settlement, the clearinghouse holds collateral from member firms to guarantee delivery. It earns interest on this collateral. The clearing fee per transaction is small, a few cents, but the aggregate volume of securities transactions makes clearing a substantial revenue business.

What the ETF manager earns: nothing from your trade

The ETF manager, whether iShares, Vanguard, Invesco, or any other sponsor, earns zero revenue from your individual ETF buy transaction. Their compensation comes entirely from the expense ratio, an annual fee expressed as a percentage of the fund's total assets, accrued daily and deducted from the fund's NAV.

What does change as a result of ETF buy activity: if net buying causes the ETF's market price to trade above its net asset value, authorized participants will step in and create new ETF shares, delivering underlying securities to the fund and receiving newly minted ETF shares in return. This creation process grows the fund's AUM, which increases the absolute dollar amount of the annual management fee. But that is an indirect effect over time, not a direct payment from your trade.

The cost you pay is not always visible

A commission-free ETF trade still carries costs. The bid-ask spread is a real cost that is paid at execution but does not appear as a line item on your trade confirmation. A liquid ETF with a tight spread minimizes this cost. An illiquid ETF with a wide spread can make a "zero-commission" trade expensive in real terms.

Market impact is another invisible cost: a large buy order that moves the price up before it fully executes results in a higher average purchase price than the price shown when you placed the order. For most retail investors with small order sizes relative to ETF daily volume, market impact is negligible. For large institutional investors, it can be significant.

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