ETFs: People Fear What They Don’t Understand | ETF Trends

A Financial Times (FT) article entitled “Bond Market Sell-Off Causes Stress in $2 Trillion ETF Industry” set off a flurry of questions about the role exchange traded funds played in Thursday’s market sell-off.

A review of basic ETF operations and mechanics illustrates that ETFs not only functioned properly last week but that they are increasingly relied upon as liquidity and price discovery tools during periods of extreme market volatility. [ETFs Face Scrutiny]

We welcome the opportunity to clarify the following concepts that were perceived to be disruptions to ETFs:

1. Emerging market ETFs trading at discounts and premiums to their NAV.
2. Authorized Participants (APs) in the ETF market and their internal risk limits.
3. The creation and redemption process and the difference between in-kind delivery and cash delivery.
4. High volumes in ETFs and investor risk tolerance levels.

1. ETF “discounts” and “premiums”

While ETFs tracking U.S. stocks typically trade in line with their underlying holdings, ETFs providing exposure to international markets that are closed during U.S. trading hours function differently. Discounts and premiums of ETFs with foreign underlying holdings are confusing to investors, and this is primarily due to the timing difference between the closing prices of two separate but related vehicles. The NAV (net asset value) of an ETF represents the closing price of the underlying basket of the ETF, with small adjustments for cash. The “last price” of an ETF represents the price at which that ETF traded most recently on the stock exchange secondary market). The two numbers are frequently compared, and the difference between them is considered an ETF premium or discount. If the stocks in the ETF all closed at 3:00 a.m. NY time, then any news and market moving events that happen between then and the closing time of the U.S. markets will be built into the ETF price but not the NAV. On Thursday, June 20, 2013, the U.S. markets sold off broadly throughout the afternoon. Expectations that the emerging markets might also sell off later that night led to lower ETF prices. The ETF prices were acting as price discovery mechanisms for where market participants expected the underlying markets to trade the following day. The NAV for that same ETF was using closing prices for the underlying stocks as they were at 3:00 a.m. NY time. The disconnect between the NAV and the ETF trading price is not really a premium or discount. The ETF price is representing the market’s view of fair value for the assets in the fund at any given moment. The NAV represents the value of those assets at the end of their local market trading sessions. [Should You Be Worried About Your Emerging Market ETF?]

2. Authorized Participants and their internal risk limits

ETFs trade in two markets simultaneously, the primary and the secondary market. The secondary market is the one most readers are familiar with—this is where individual investors and advisors can buy ETFs just as they buy stocks through a brokerage account. However, behind the secondary market, there is a primary market where ETFs are created or redeemed between the ETF sponsor and what is known as an Authorized Participant, an ETF market maker or other large financial institution. The AP is acting as the conduit between the firms providing liquidity in ETFs to customers trading in the secondary market, and the ETF issuers that are enabling creations and redemptions of ETF shares. APs are typically the ETF trading desks at the big brokerage firms, and all those trading desks have limits on how much risk they can facilitate in their trading portfolios on any given day. If an AP is very successful in its business, it has attracted a lot of “clients” (liquidity providers) to run their creations and redemptions through its firm. On busy days like June 20, the firm can become a victim of its own success and reach its own internally placed risk limit as to the size of the positions it can facilitate. I suspect that was the case with Citigroup, mentioned in the FT article because it ceased accepting redemptions. From an end-investor perspective, this means nothing. It does not affect the pricing of the ETF in the secondary market; it simply means the liquidity providers must go to a different AP to create or redeem the ETF shares they are trading. Typically, there are large numbers of APs for each ETF. WisdomTree, for example, has more than 20 different firms authorized to create and redeem shares. Any of those firms will pick up the slack in the market, facilitating creations and redemptions when other APs cannot. This actually highlights the dynamics of a well-developed network of liquidity providers and the authorized participants that service them.

3. The difference between in-kind and cash creations and redemptions

A typical, in-kind creation of an ETF involves the authorized participant delivering the actual securities, in the right proportions, to the ETF issuer, who is then able to issue new shares of the ETF.