Exchange Traded Funds (ETFs): A Quick Primer
ETF assets continue to show robust growth in assets. According to Morningstar, ETF assets rose 20 percent last year to $2.55 trillion, while growth has averaged 19 percent a year over the last ten years. Investor demand has largely been driven by the ETFs cost and tax efficiency, transparency in holdings, and the creative product innovation across multiple asset classes. So, given its wide appeal, it makes sense to discuss what an ETF is, and how it works.
- ETFs are a portfolio of securities designed (in most cases) to track an index.
- ETFs provide liquidity, as they are exchange listed and have intraday trading.
- ETFs are highly transparent, as holdings are published daily along with Net Asset Value (NAV).
- ETFs are tax efficient as capital gains are ‘managed’ as opposed to being triggered by (net) redemptions.
- ETFs provide simple fee structures as opposed to multiple fees and share classes associated with mutual funds.
- ETFs offer creative and innovative investment strategies from equal to cap weighted index exposure to multi-asset class strategies in developed and emerging markets.
The Mechanics – How ETFs are Created and Redeemed:
The ETF creation and redemption process allows for an increase or decrease in the number of shares outstanding based on investor demand. This feature is unique, as buying and/or selling of shares has no impact on other investors, as it would in a mutual fund.
For example, with ETF creation, if Investor A wants to purchase 50,000 shares of ETF-1, he would go to his ETF Broker (an Authorized Participant who deals directly with the ETF fund company) and the broker would sell him 50,000 shares of the ETF-1 at an agreed upon price. In turn, the broker is now short the ETF-1 shares, and therefore needs to purchase the underlying securities/holdings in the open market to deliver to the ETF issuer/company, thus initiating a “creation” of ETF shares. The broker then receives the new ETF-1 shares from the ETF issuer/company in exchange for the in-kind (underlying) securities/holdings, which offsets the short ETF-1 position. Exhibit 1 illustrates the process of ETF creation.
Exhibit 1: ETF Creation
Key Points to Consider:
- The ETF creation process is typically done only with larger transactions, such as 50,000 shares or more. This mechanism allows for added liquidity and minimal disruption in daily trading when a larger buyer wants to purchase shares in an ETF. Smaller orders are typically filled via the ebbs and flows of daily trading volume.
- Keep in mind, the ETF is simply a basket of securities. Once the larger buyer of ETF shares is filled by the broker, the broker, in turn, purchases the underlying in-kind securities in the open market to deliver to the ETF issuer, in exchange for shares in the ETF.
In the previous example of ETF creation, Investor A owns 50,000 shares of ETF-1. Now, Investor A wants to sell his shares in ETF-1. He contacts his broker and they agree to a price and complete a trade. Investor A’s transaction is complete. The broker now owns the shares in ETF-1, and subsequently goes into the open market to sell (short) shares in the underlying securities/holdings in ETF-1. The broker is now long the ETF shares and short the underlying securities/holdings in ETF-1. The broker then initiates a “redemption” by delivering the ETF-1 shares to the ETF issuer/company in exchange for in-kind securities/holdings in ETF-1. The broker offsets his short position, and the transaction is complete. Exhibit 2 illustrates the process of ETF redemption.
Exhibit 2: ETF Redemption
Key Points to Consider:
- Larger orders in ETF shares are typically executed with little to no disruption in the marketplace due to this unique creation and redemption process.
- The redemption process allows for an in-kind exchange of underlying securities (bought in the open market) in exchange for shares in the ETF, thus allowing for tax efficiency. In other words, selling by other investors doesn’t trigger a sale of securities that may have an embedded capital gain that would otherwise have tax consequences for all shareholders.
- The in-kind exchange of securities/holdings for ETF shares allows for the management and timing of capital gains.
 Source: Morningstar, “Three Key Trends Driving ETF Growth”, 2.22.2017
Written By Robert Okada, CFA®