Outside-IN

Putting the T back in ETF

Understanding a fundamental benefit of exchange-traded funds

Feb 24, 2015 @ 12:01 am

By Grant Engelbart

Exchange traded funds are exceptional tools for allocating client portfolios, but they can lose their effectiveness if implemented incorrectly. The “T” in ETF is often neglected by both new and long-time users of ETFs. A simple review of the often mystical world that underpins ETF trading can be helpful.

To start, ETFs essentially trade in two distinct markets.

Let's start with the secondary market — what is referred to as the “on-screen” market. The quotes we all see on the screen when we punch in an ETF ticker is the price one would pay in the secondary market. Trading in the secondary market is very similar to trading a stock.

(More: Building a successful ETF portfolio requires more than strategic allocations)

The other, perhaps more important market, is the primary market. Only specific “authorized participants,” or APs, and the ETF sponsor can transact in the primary market which are referred to as creations or redemptions. Creations occur when the ETF sponsor creates new shares of the ETF (typically in 50,000 to 100,000 share blocks), in exchange for shares of the underlying securities by the AP. Redemptions are the reverse transaction, where the AP can provide shares of the ETF to the ETF sponsor in exchange for the underlying securities. These transactions both occur at the net asset value of the ETF, not at the “on-screen” price we see in the secondary market. The exchanging of ETFs shares for securities is often described as an “in-kind” transaction.

With me so far?

While it may feel convoluted, it is imperative to understand the creation/redemption process, as it drives the way ETFs trade. Let's take a first-person look at it. I want to buy 50,000 shares of XYZ — we'll say that XYZ is an ETF that tracks the S&P 500. I could try and buy XYZ in the open market by myself, but XYZ only trades around 15,000 shares per day, so it would take a while — and I want the trade done today. So I contact my broker, who happens to be an AP with XYZ's ETF sponsor. I let my broker know my intentions, and he comes back with a quote. I receive the shares and pay the broker the necessary commission. Sound simple enough? My job is done, but it is important to understand what makes that seemingly simple process possible.

BEHIND THE SCENES

As mentioned before, there are really two markets. The secondary market for XYZ isn't particularly liquid, as the ETF only trades around 15,000 shares per day. However, remember, XYZ tracks and holds the stocks in the S&P 500, a basket of the most liquid stocks in the world, so there is a lot of underlying liquidity that an AP can tap into. Generally, that is done in the primary market.

(More: Investors flock to low-volatility ETFs as stock market swings widen)

There are a number of ways that brokers manage risk and positions; however, let's focus on a simple scenario where they interact with the ETF sponsor to create or redeem shares.

Back to our example: my broker just sold me 50,000 shares of XYZ, so he now has a short position he needs to cover. To do so, he purchases all 500 stocks in the S&P 500 and then asks the ETF sponsor for the 50,000 shares of XYZ in exchange for the stocks. The price of the underlying stocks may be slightly different than the NAV of the XYZ shares, for better or worse, but in most cases the broker wouldn't be doing this transaction to lose money.

There are costs associated with this transaction, but generally those are reflected in the broker's quote. This process in practice is most likely done on a larger scale as traders manage their large position books; but in general, the ability to create and redeem drives how ETFs trade, and is what makes them unique.

So, why did I have to go through the trouble of contacting my broker? Couldn't I just put in a market order for those 50,000 shares of XYZ? (If you see someone cringe when they hear market order, they are most likely involved in the ETF business.) A market order would, by nature, guarantee execution of those shares but it would send the price of XYZ soaring. Remember, XYZ has an underlying NAV, and that NAV wouldn't change when I bought the ETF, so other brokers and authorized participants would quickly arbitrage that anomaly away. I would be left with terrible execution and likely be the laughing stock of a few Wall Street trading desks. No one wants that.

Of course, there are many nuances beyond what I described here, but hopefully this provides some insight into what occurs in the ETF marketplace.

The ETF industry is built on partnerships. ETF sponsors need brokers to trade their ETFs, and both sponsors and brokers need us — the end users of ETFs — to buy and sell them. The ETF sponsors are more than willing to help out with trade execution as they all have capital market desks designed to do just that. A trusted broker relationship can be invaluable, as brokers can guide clients in effective methods of ETF execution. Of course, utilizing a third-party ETF strategist who has relationships across the industry can be critical too.

Now that you understand a little more about ETF trading, your clients can benefit from of the exceptional diversification and low costs of ETFs, and take advantage of the intraday liquidity inherit in the product.

Grant Engelbart is a portfolio manager at CLS Investments.

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