Exchange Traded Funds-Part 1: How ETF's Are Traded

Exchange Traded Funds or ETF’s are becoming one of the most popular investment vehicles by both retail and institutional investors. ETF’s track the returns of a variety of major global stock indexes as well as local, industry, and geographic indexes. In other words, if the S&P 500 index was up 5 percent over the course of a year, then the ETF product would also rise 5 percent (less management expenses, other tracking errors).They also can be structured to mirror the returns of other assets such as bonds and specific commodities. The beauty of ETF’s is they provide instant exposure to an asset class at a much lower cost than traditional products like mutual funds. Unlike mutual funds or other pooled assets which are priced once a day, ETF’s trade alongside individual company stocks allowing investors to buy and redeem shares in real time. Many years ago, there were only a handful of Exchange Traded Funds that mirrored the returns of major indexes like the S&P500 or TSX S&P Composite indexes. Today there are hundreds of ETF’s that passively invest in major indexes or are managed based on a specific ideology (e.g. value, growth) or other unique quantitative algorithms.

What’s different though with ETF’s versus a company stock is that a company has fixed amount of stock outstanding at any time. An ETF on the other hand can issue new stock and redeem stock depending on demand of the underlying fund. As ETF’s become more complex in scope, it becomes more important for investors to understand how these assets are traded as it can provide insight into identifying more efficient strategies for maximizing their effectiveness. Unfortunately not many people, including people working every day selling these products know how they work. In the first of our 2 part series, we look at the process for how ETF’s with assets domiciled domestically get traded as well as how ETF’s with international exposure get traded. There is a difference and it can impact the valuation. The good people at Krane Shares wrote an excellent piece about the process and I will try to capture their key concepts.

How ETF’s Trade

In the ETF process, there is one party which acts as a middle man between the investor, the ETF company and the stock market and they are the Authorized Participant (AP). The AP is essentially the brokerage firms. If you follow the money flows and paper flows, it all goes through the AP.

ETF providers (e.g. iShares, Vanguard etc), like traditional mutual fund companies, can create or redeem shares on a daily basis. In traditional mutual funds, the mutual fund company facilitates the creation and redemption of shares. In an ETF, Authorized Participants are brokerage firms that create and redeem ETF shares by delivering or receiving the ETF’s underlying basket of securities that makeup the index being mirrored. Every night ETF providers send out a portfolio composition file that is essentially instructions of how to build or dismantle an ETF. In the case of a purchase, when an investor wishes to buy an amount of ETF shares that is greater than what is available to sell in the market, the Authorized Participants will buy the underlying securities that comprise the index the ETF is trying to mirror and deliver those shares to the ETF provider. In return the AP receives from the ETF provider, the ETF shares which are then passed on to the investor. The chart below shows how the process works.

Source; Krane Securities

Source; Krane Securities

How International ETF’s Trade

This is all and good if the index is active at the same time as the market it open (e.g. buying an S&P 500 index while the US stock market is open). However what happens when an investor wishes to buy an ETF that is mirroring a foreign index that is likely not opened (e.g. A North American investor wishes to buy an ETF that invests in the Nikkei Index in Japan)? International ETFs differ in that the underlying securities' markets tend to be fully or partially closed during North American trading hours. In order to facilitate buying and selling in international ETFs, APs often hold an inventory of ETF shares. By owning shares of the ETF, the AP will hedge the exposure through a variety instruments such as futures, shorting the underlying basket of stocks or other similar ETFs.

When an Active Participant does not have sufficient ETF shares in their inventory, the prices that are quoted are basically educated guesses on where the AP “thinks’ the securities could be purchased the following day when the International markets are re-opened. Ultimately the price quoted will be based on several reference factors, namely:

  • The underlying securities’ currency movement versus North American currencies during North American trading hours.
  • Market news that may affect the underlying stocks’ market.
  • North American stock or sector movement that may affect the ETF’s underlying securities.
  • ADRs are certificates issued by US banks used to facilitate trading of foreign securities on US exchanges. The movement of ADRs can provide a potential indicator where the underlying securities and market will open the next day.
  • Stamp taxes and exchange fees are also incorporated into the bid-ask spread. For instance the Hong Kong has a stamp tax of 0.2% per security transaction. APs are responsible for paying the stamp tax which they will include in the price quoted.

 As we can see, the pricing of these international ETF’s becomes more of an art than a science nor can pricing have anything to do with economic fundamentals such as supply and demand. In a way these types of ETF’s can easily become black boxes. This lack of transparency could be very impactful in an extreme and volatile market event. From this perspective, one could make a good argument for buying individual stocks as these pricing elements are more or less removed from the market.

I have always been suspicious of the behaviour of International ETF’s.  From my own experience, I’ve owned a variety of ETF’s that mirror foreign indexes and have seen unusual pricing patterns both on the up and downside. As a result, I’ve leaned away from using these foreign type ETF’s and have moved instead to investing in blue chip companies from that sector, geographic region, or index. I'm more now inclined to use ETF's that mirror markets that are liquid and in the same geography such as the North American indexes. The blog My Own Advisor has a nice breakdown of the options available for Canadian ETF's.

One of the primary benefits of ETF’s is that they provide instant diversification with lower fees. What they do not provide all the time as the good people at Krane Shares has shown, is 100 percent price discovery especially when differences in geography and time zones are involved. Granted over the long-term these short-term variances are smoothed over. Unfortunately, ETF’s are being marketed as trading products and not necessarily long term investments and consequently many investors who are unaware of how they traded, could be in for a lot of head scratching wondering why their Emerging Markets ETF is not behaving the way the markets overall are behaving. With ETF’s increasing in volume and variety, it becomes even more important to understand the mechanics of how these products are traded as any significant market events can have a profound impact on their true value which will ultimately impact your portfolio.

In part 2, we will review some strategies ETF’s that investors should be mindful of when executing the buying or selling of Exchange Traded Funds. (See: Exchange Trade Funds-Part 2: Trading Strategies to Avoid)