How does the Nasdaq 100 tracking stock operate? If the buy and sell orders for a day are out of balance, does the trust buy or sell the basket of stocks? If it doesn't, how does it maintain a constant ratio?

-- Ed Schoenberger

Ed,

Readers have shown such an overwhelming interest in the new Nasdaq 100 tracking stock (QQQ:AMEX - news), created by the Nasdaq-Amex Market Group, that I felt obligated to answer your question as soon as it came in.

The Nasdaq 100 shares trade on the American Stock Exchange just like a stock. I have said that before, but what does it mean? As with stock trading, a specialist firm facilitates transactions on the floor of the exchange and is responsible for keeping an orderly market in the securities.

If you buy these new Nasdaq 100 shares, you actually are investing in a unit investment trust that holds shares of the companies in the Nasdaq 100 index. The trust was built to track closely the price and yield performance of this underlying index.

The trust literally owns all the stocks in the Nasdaq 100 index. But it doesn't have a fixed number of shares and can always grow. But the trust will not expand like your typical mutual fund.

New shares can be created by the specialist or larger investors in increments of 50,000 shares. Here's how a creation would work:

Say a large institutional investor wants to create 50,000 shares of the trust. That investor would have to go out and buy all the stocks in the Nasdaq 100 that are needed to create that many shares of the trust. Then the investor would have to the give those shares to the Bank of New York, the trustee for this trust. In return, the Bank of New York issues the investor shares in the trust. (Redemptions would be conducted in the same manner, just in reverse.)

This creation process is not really relevant to individual investors. If you wanted to buy shares of these instruments, you would call your broker. You would not need to (or really be able to) go through this "creation" process. There are existing shares trading on the exchange that are readily available for purchase.

As you can see, the trust itself does not actively buy and sell the stocks every day. All the trust does is take creation and redemption orders and administer and collect dividends.

If there is price imbalance between the Nasdaq 100 tracking stock's share price and net asset value, or NAV, here's what may happen, according to Michael Bickford, senior vice president in derivatives research and market for Amex:

Say the NAV of the trust is 100 a share. A large influx of orders comes in to sell. That may drive to the actual share price down to 99 1/2. There aren't other buy orders out there. "At some point, someone is going to see that imbalance," says Bickford.

A large investor might buy these Nasdaq 100 shares and turn them into the trust, get the underlying stocks in return and then sell the stocks in market place, thereby capturing this price difference. This type of arbitrage is not something the average individual investor would do. But it is the mechanism that keeps the price of the Nasdaq 100 shares close to the NAV, unlike a closed-end fund that can trade at a discount or premium to its NAV, says Bickford.

If the imbalance is on the other side of the equation, and there is more demand than shares available, the specialist may create new shares in increments of 50,000, as discussed above.

Nasdaq's Web site offers reams of information on these securities. If you still have questions, you may want to take a look.