chrisc
Member
Hi,
Can someone correct me if I'm wrong with my understanding of ETFs please. I've searched all over and can't find anything that will answer this question.
For arguments sake, lets take the SPY etf that follows the S&P500. If a company was removed or added from the S&P500, wouldn't all the ETFs that follow this index be required to buy or sell the stocks for the given company? Wouldn't this create a run on the price and really mess things up? How does this work in real life?
Much appreciated.
Tom
Member
Thanks for your excellent question, chrisc. We'll research this and get back to you.
chrisc
Member
Thanks for the reply. I want to add more details to the initial question.
For this argument I’m going to use:
iShare Canada LargeCap 60 (XIU): Asset Value ~ $9B
http://ca.ishares.com/product_info/fund_holdings.do?ticker=XIU
The smallest company on XIU’s list of holdings is MDS Inc (MDS) currently trading at $6.40 and a weight of 0.07% of XIU. MDS Market Capital = $768.88M.
If I take 0.07% of $9B, that gives me $6.3M or ~1M shares of MDS. Except for a couple of outliers the average volume of trading MDS seems to be 100K - 500K per day.
Hypothetically, if MDS was to be removed from the LargeCap 60 index, XIU would be forced to sell all it’s shares in MDS and buy its replacement correct? Since XIU is a passively managed investment, the manager does whatever the market tells him to do. In this case the manager would be required to sell MDS asap. If 1M shares of MDS suddenly became for sale, wouldn’t that drive down it’s price and flood the market. In contrast, wouldn’t the new company to be added to XIU receive a huge increase in demand and prices sky rocket?
I appreciate all the help.
Thanks.
Tom
Member
Any index fund (ETF or MF) with a replication methodology would have to follow any changes to the underlying index (S&P 500 or any other index) but some ETFs or MFs may use an optimization or sampling methodology and would not necessarily have to follow such a change, particularly if the change was in a name with a very small, almost meaningless, weighting to a particular stock.
That said, even funds that must replicate its underlying index have some degree of flexibility around when they make the changes by buying or selling stocks based on index changes. The manager may have a period of a few weeks over which to make the trades so that not all the index funds following a particular index will be in the market at the same time buying/selling the stocks going in/out of the index. Index changes do appear to create some degree of volatility around the stocks going in/out of an index but the degree can vary greatly based on a number of factors such as the liquidity of the stock, index weighting, $AUM tracking the particular index…
In the well-followed indexes, most people know what’s happening and most of the arbitrage is taken away. That being said, it’s usually beneficial for companies when their stock enters an index because there is natural demand for their stock from index holders.
However, here’s an example from the last S&P 500 index addition on June 30th:
Stock: WDC
Weight in S&P 500: 0.0733%
Average Daily Trading Volume: 5M shares
Shares traded on 6/30: 50M shares
% Price Change on 6/30: 0.04% (up 1 penny from 26.49 to 26.50)
Conclusion: 10x the amount of volume, but not much price impact.
Hope that helps you, chrisc.
chrisc
Member
Thank you for the detailed response. That answered my question.
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