Though many investors are familiar with the comparative features and uses of ETFs and mutual funds, not everyone knows the trading mechanics that underpin these instruments. The unique creation and redemption process through which ETFs are traded creates value relative to the comparable mutual fund process.
Unit investment trusts (UITs) and open-end ETFs continuously offer shares through a daily in-kind purchase and sale (creation and redemption) process that reflects demand and increases transparency. Creations and redemptions occur at prices based on the next calculation of the net asset value (NAV), enabling market makers to match even slight premiums and discounts to the NAV.
The process involves only a few large investors, known as authorized participants (APs). APs are typically large institutional organizations, such as market makers or specialists. Only APs can create or redeem units.
In a creation transaction, an AP assembles a portfolio of stocks and turns them over to the fund in exchange for new ETF shares. Similarly, for redemption transactions, authorized participants deliver ETF shares to the fund in return for the underlying portfolio of stocks.
No cash changes hands during the in-kind process. Each day the funds underlying holdings are disclosed to the public.
ETF vs. Open-Ended Mutual Fund
A traditional open-end mutual fund structure has one level of trading activity (see Figure 1). Investors exchange cash for shares in the fund based on the net asset value (NAV) or offering price calculated at the end of each business day1. Investors can make transactions each business day after that price is posted and only at that days price.
By contrast, ETFs have two levels of trading activity primary and secondary. This distinction is vital to understanding how an ETF works (see Figure 2).
EFT Primary Market Creation/Redemption
In the primary market, APs exchange a published basket of securities in-kind plus a published cash component in exchange for ETF shares. These baskets are generally very large, and one creation or redemption unit is equal to a fixed number of ETF shares. The ratio varies by product, but is usually 50,000 ETF shares per unit.
Net Asset Value
Basket (securities) + Non-Basket (cash component) = PCF = NAV
A single creation unit consists of the published basket of securities plus a cash component to equal the NAV per unit. From a bottom-up perspective, the non-basket (cash component) is primarily comprised of dividend and tax accruals, expense accruals, cash and restricted securities. Restricted securities could be odd lots that dont fit into the basket, or securities that are for some reason restricted from trading.
Creations and redemptions occur at the end-of-day NAV, where the value of the securities basket plus the cash component equals the NAV, so there is no dilution to existing shareholders. The published securities basket along with the published cash component is called the portfolio composition file (PCF) and is distributed to AP and market data vendors as well as service providers.
The intraday value of the underlying PCF on a per-share basis is called the indicative optimized portfolio value, or IOPV. For each ETF, Bloomberg (a financial market information firm) provides a ticker for the ETF shares, the IOPV and the underlying index. The IOPV value represents the underlying basket of securities plus the cash component and is updated every 15 seconds through the trading day. The IOPV helps market participants relate the value of the fund and its underlying securities to the value of the ETF shares trading in the secondary market on the exchange.
Arbitrage and ETF Pricing
Arbitrage activity not only seeks to efficiently match the outstanding supply of shares with demand, but also eliminates trading at large premiums or discounts to the NAV. This helps support closer tracking between the exchange-listed ETF shares and the funds NAV.
Most analyses comparing the costs of using futures versus holding underlying securities versus ETFs consider only the case of an investor limited to transacting at the ETF share level. However, the economics of two different ETF transactions must be considered.
If the investor is an AP, he or she is faced with a situation in which futures, securities and ETFs are fungible. That is, if you buy either futures or the underlying securities, you can easily convert to ETF shares via creation units. (This assumes that a liquid futures contract exists on the same index and the market's price at the same time.)
This creates the arbitrage opportunity relationship that forces ETF shares in the secondary market to trade relatively in-line with their underlying securities. Three examples illustrate this relationship.
Example 1: ETF shares look cheaper than futures or underlying securities. Investor (AP) decision: consider ETF shares.
Example 2: Underlying securities look cheaper than futures or ETF shares. Investor (AP) decision: buy securities, convert to a creation unit and end up holding ETF shares.
Example 3: Futures look cheaper than underlying securities or ETF shares. Investor (AP) decision: buy futures, exchange for securities, convert to a creation unit and wind up with ETF shares.
These examples have been included only as hypothetical illustrations and not as a comprehensive list of possible relationship dynamics between the primary and secondary markets.
The assumptions of fungible futures and same-time trading/pricing do not hold in international markets or in some U.S. markets due to differences in market hours. Where that is the case, premiums and discounts tend to exist intraday and revert day-over-day. In addition, markets affected by a Stamp Tax (the United Kingdom being most notable) can cause certain markets to always trade with a rich basis to the IOPV. This effect results from taxes incurred during the creation process when buying the basket of underlying securities.
Management fees which accrue over time reduce the total return received from holding ETF shares relative to futures or a basket of actual securities. Expense ratios of ETF shares vary based on the particular fund, with more specialized exposures costing more.
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1 NAV is a funds price per share, which is derived by dividing the total value of all the securities in its portfolio, less any liabilities, by the number of fund shares outstanding.