The ETF - process

You can’t talk about without mentioning the creation-redemption process, which is quite unique in the fund management space.

A practical example

Here is a practical example of the creation redemption process. Let’s say that you buy an ETF, say a financial sector XLF, during the day.

You ban an ETF
  • Somebody has been quoting that instrument on the stock exchange for you; that market-maker, when he sells it to you, has to hedge himself. There are no financial index , he has to buy the components of the index which the ETF tracks. And so the market-maker buys the ~65 stocks representing the ETF/index of the ETF, each in the right quantity.
Market maker sells and hedges ETF
  • Now the day passes by, and people buy and sell, but eventually that market-maker has a residual position at the end of the day. Let’s say that today he has sold a lot of ETFs.
  • That market-maker has to deliver them to you and to the other buyers. He doesn’t have them – he has the shares he has bought for his hedge.
Inventory
  • That market-maker then contacts the fund manager to obtain these ETF units.
    1. So he sends an email (actually logs his request into a dedicated website). But essentially, he is saying “I’d like to create 1.2 million XLF shares tonight”. The fund doesn’t do retail quantities, only institutional sizes. The clip size is typically 50,000 ETFs, for some ETFs, it is 100,000 units. That minimum quantity is called the creation unit.
    2. Now, how should the market-maker do this creation process, practically speaking? He has shares, and wants ETF units. Should he sell all his shares on the close and use the cash proceeds to buy a unit from the fund managers also on the close? That ETF portfolio manager would then use the cash to buy those same shares on the close (aka invest in the assets).
    3. That’s inefficient, and also you would need time to do this. And if the market-maker has sold a lot of ETFs on the close, it’s too late for him to sell the shares also on the close to generate the cash he needs.
  • So that’s where the creation-redemption process comes in. Instead of buying ETF units from the fund, the market-maker exchanges his shares for fund units with the fund manager. He literally deliver to the fund manager the same shares he has bought for his hedge (and a tiny bit of cash) and he will receive the new ETFs from the fund portfolio manager. This process is an in-kind creation, which means that the market-maker delivers shares, not money, to receive units.
Market-maker creates units
  • Two days later, the exchange (actually, the custodian) settles the operations. It exchanges the ETFs against cash ($$$) at the traded price. That happens both for the market-maker and the individual investor (you).
Settlement
  • Now, the quantities and the cash amount for this creation are very well known in advance. The fund manager has actually distributed these quantities in the morning. The market-maker actually used those published quantities to perfectly hedge himself during the day.
  • BTW, these quantities allow him to perfectly recalculate the value of the unit in real-time – he knows the quantities of each of the shares, and the price of each the shares (and the tiny bit of cash), and therefore he can recalculate the value of the fund units extremely accurately.

Last thing, a market-maker who has the right to create and redeem ETFs with the fund through this process has a special name. He is called an “authorized participant”, an AP. Not everybody can be an AP. It’s a professional’s job. And not all market-makers are APs, but the reality is that APs are generally market-makers and market-makers are generally APs, so market-makers and APs are pretty much the same thing.

The main benefits of this in-kind approach

Here is a practical example of the creation redemption process. Let’s say that you buy an ETF, say a financial sector XLF, during the day.

What are the main benefits of this in-kind creation approach?

  • There is no execution risk for the market-maker or the fund manager. 
  • You can give the creation instruction AFTER the market has closed.
  • The fund manager doesn’t have to keep a bunch of cash at hand for buying further stocks, like the old mutual fund manager would have to (the new units are often paid later than the share purchase). So the ETF manager can be 99.9% invested in the market, not 98% invested like a regular mutual fund manager is. That missing 2% is known to create an underperformance for mutual funds when the market rallies.
  • A redemption is the similar creation process, but in the opposite direction; the ETF fund manager has to deliver shares and receive back some ETF units from the market-maker. In a redemption, the delivery of the stock components from the component (the in-kind delivery) is not considered a taxable event. So the fund manager does not incur ST or LT capital gain when his fund grows or decreases. This is good for the other investors in the fund.
  • Last but not least, the creation-redemption process is virtually cost-free (except in some countries like the UK, where there is stamp duty). This means that the market-maker can quote the ETFs during the day with a very narrow bid/offer spread.

Some of the difficulties with ETF creations & redemptions

This creation redemption process can be a bit difficult. Operation professionals will appreciate the following issues:

The shares and the ETFs are delivered in kind. That means “for free”, which means they are sold at a price of zero

  • Now, for global ETFs, where the components are in various countries and currencies, it’s a bit of a pain. If you receive an ETF in dollars, then you have to deliver the component shares also in dollars otherwise you create a gain in a currency and a loss in the other. 
  • So you have to teach your system that your Swiss share (quoted in Swiss Francs) has to be settled for zero dollars, not zero Swiss francs
  • Most systems don’t like this one. It’s a bit of a pain. Trust me. Especially for a truly global ETF like an EFA.

There are shares and countries that you are not allowed to go short stock

  • Let’s say for instance that your client sells to you an EFA ETF.
  • As part of your hedge, you need to sell shares in every country, including in South Korea.
  • In that country, you are not allowed to short shares (sell shares that you don’t own first.
  • So if you have an empty book and you buy an EFA ETF from a client, you can’t sell the component short for your hedge in South Korea

=> In other words, you have to take a correlation risk, meaning that you don’t hedge them. You become implicitly long exposure to South Korea.

What about shares that you are not allowed to trade?

  • Market-makers are often bank employees, and banks are always restricted on some shares due to their M&A operations.
  • There are shares that banks are also always restricted from – like VISA and Mastercard. That’s because credit card issuers are only entitled to own A-shares, not the B-shares listed in the market. If they were to buy B-shares in the market, those B-shares would immediately convert into A-shares. And those A-shares would not hedge the ETF, but are actually impossible to get rid of.
  • Again, that’s a funny one. Needless to say, VISA and Mastercard are not small weights in the S&P and certainly in the financial sector.
  • Unsurprisingly, have taken over the business of market-making ETFs.
    1. Not only they do not participate in M&A operations and are therefore have no restricted stocks.
    2. Needless to say, hedge-funds don’t issue credit cards.
    3. Last quality, hedge funds are much more nimble organizations. They can allocate the resources needed to create the trading & risk systems very quickly.

And there are currencies that you can’t short either. I’m thinking again of the South Korean Won. So how do you buy shares in Korea if you don’t have Korean cash to start with?

And how many FX trades do you have to do when you trade and hedge a global ETF? The ETF is in dollars. Each of the countries are in Euro, Japanese yen…

And how do you calculate the value of a global ETF when half the shares are not open for trading and their prices are stale?

Etc, etc…

Now another more difficult problem: what do you do when the strategy in the fund cannot be replicated – like when the components are not tradable

  • I’m thinking of the which is a purely theoretical index that can’t be well replicated or traded by itself with options. 
  • Or a basket of bonds, which are traded only OTCs, and are often illiquid
  • Then you have to revert to a ‘cash’ creation, or you cross futures with the funds.
  • Same for the VISA and Mastercard shares – you need a derogation from the fund manager to never have to deliver or receive these shares from the fund manager, and the fund manager has to buy them in the market, etc… which means he has to be instructed before the market closes. Or you can transfer the exposure with a swap, IF the fund has an ISDA…

 

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