Explain how ETFs work

Factual Questions
1

OK, to be more specific, I have a bunch of ETFs in my portfolio. One of them - FXI - had the following story today: http://www.thestreet.com/_yahoo/funds/etftuesday/10345285.html?cm_ven=YAHOO&cm_cat=FREE&cm_ite=NA

Specifically, I need someone to explain the following (excerpt from the article):

*There seems to have been an increase in anti-ETF sentiment of late. For example, over the weekend, a must-read article in The Wall Street Journal explored a potentially important trading issue that manifested itself during the recent market turbulence.

According to the article, the iShares FTSE Xinhua China 25 Index Fund strayed more than 7% below its underlying net asset value on Feb. 27. The article then notes that most of that gap closed the following day – a price within 0.5% of NAV is considered normal. Unfortunately, the data on the iShares Web site was not current enough for the discrepancy to be seen firsthand.

The article rightly points out that anyone selling FXI on the 27th was effectively short-changed, while buyers lucked out and got a small boost as the gap closed.

In a lot of the articles I write about new ETFs, I suggest giving a new fund a little time to season. That advice doesn’t apply here, because FXI has already been trading for a while.

The fund strayed from its NAV at a time of elevated fear in the market, and this strikes me as the type of thing that might happen again. *

How can the NAV of an index linked fund ‘stray’ from the actual index price? Is it because there are a finite number of ‘shares’ of the ETF and therefore the ETF is affected by supply and demand like a stock?

2

There’s a good little article here that explains ETFs. The short answer is that a share of an ETF can be redeemed for the actual underlying securities.

3

Here is what FXI says about their ETF.

The investment seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the FTSE/Xinhua China 25 index. The fund generally invests at least 90% of assets in the securities of the index or in ADRs, GDRs or EDRs representing securities in the index. It may invest the remainder of assets in securities not included in the index. The fund also may invest other assets in futures contracts, options on futures contracts, options, and swaps related to the index, as well as cash and cash equivalents. It is nondiversified.

Also, remember that FXI shares will trade on the NYSE as well as the ADR’s associated with it. Obviously, there is a time gap.

ETFs aren’t perfect. There are times when the Dow will be up a tiny amount, but DIA will be down.