Today many investment advisors and individual investors use ETFs or exchange-traded funds rather than, or in addition to, individual stocks and bonds or mutual funds. Today about 25% of all equity dollar volume is accounted for by trading in ETFs. Most of that volume is concentrated into relatively few ETFs.
Given that ETFs are typically designed to track certain indexes, how are ETF shares created or redeemed in response to supply and demand for the ETF?
When new ETF shares are introduced into the market, brokerage firms called authorized participants (AP’s) engage in a process called creation. Creation units is the term for the block of ETF shares that the AP will exchange for underlying securities that it acquires in the open market or from other means. Each day the AP gets a file from the National Securities Clearing Corporation (NSCC) that details the exact securities required for a creation unit. (So one of the biggest ETFs the SPDR S&P 500 index ETF would have is 500 components.) The underlying securities are then delivered to NSCC and the ETF sponsor (who is an entity like iShares by Blackrock or State Street SPDR’s) is responsible to deliver the ETF shares to the AP’s account at NSCC. Redemption or retiring shares from the market is the same process in reverse. This process allows immediate liquidity for an ETF (trading throughout the day) as opposed to the end of day pricing for mutual funds. If you buy or sell an ETF you get the market price at the time of sale or purchase, and if you buy or sell a mutual fund you get the net asset value (NAV) of the fund at the end of the trading day.
One of the important issues when trading thinly traded ETFs is to use limit orders to protect you from premiums or discounts to the value of the underlying basket of securities and creating an arbitrage opportunity for the AP. In fact, it’s usually a good policy to use limit orders on all equity type orders.
All of this should be clear as mud, and just touches the surface of the trading and back office functions related to ETFs, but the ETF industry is a large and growing part of Wall Street. New ETFs are being created every day with actively managed ETFs designed for different strategies being the next big marketing push and hoped for growth area. The market for passive index ETFs is saturated and the only way the products can compete with one another is by charging the lowest fees.
ETFs promise to offer increasing opportunity and complexity in terms of strategies and in the way that advisors and investors will use them in terms of asset allocation and portfolio construction. It’s important for the advisor and/or investor to understand how these products are constructed and traded and the fees and other costs associated with using them. As always, don’t make investments in things you don’t understand. Hire someone you trust to help you.
James Mathis, managing partner of Echelon Investment Management, believes in enriching his clients’ lives by identifying, preserving and achieving their goals. Echelon partners with clients through every leg of their race ~ asset management, investment advice and retirement planning. Contact him at james.mathis@echelonim.com.
Disclaimers: The ideas presented here are for illustrative purposes only. This does not reflect the performance of any specific investment. It should not be assumed that past performance in any way relates to future results. The information herein has been derived from sources believed to be reliable, but this is not a guarantee as to the accuracy and does not purport to be a complete analysis of the security, company or industry involved. An investor should consider, before investing, whether the investor’s or designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s 529 college savings plan. 529 plans are subject to enrollment, maintenance, administrative and management fees and expenses. Non-qualified withdrawals are subject to federal and state income tax and a 10% penalty. Please consult with your financial advisor and tax advisor to determine the strategy that best suits your individual needs.
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