A typical in-kind redemption works the same way in reverse: The AP delivers ETF shares to the ETF issuer, and the issuer delivers the underlying basket of assets to the AP.1 This process involves the AP doing the trading of the ETF and its underlying assets.
However, to facilitate processing ease for authorized participants in certain funds, ETF issuers will sometimes allow them to create and redeem ETF shares for cash—this is known as a cash creation or redemption. In this case, instead of delivering or receiving the underlying basket, the issuer will take or deliver cash and actually go out into the markets and facilitate the trading of those assets. At certain times an ETF issuer can restrict cash creations or redemptions, which is what happened last week, according to the FT article. All this means is that APs have to go into the markets and trade the underlying assets, or in the case of a redemption, that the AP will receive the actual underlying assets and will have to sell them in the markets instead of just receiving cash. One of the main reasons for an issuer to do this is to preserve the tax efficiency of the portfolio for investors. This has no impact on the normal functioning of the ETF or of the arbitrage mechanism that keeps an ETF trading at close to its fair value throughout the day.
4. High volumes in ETFs
The high volumes in ETFs on June 20 were actually not an abnormal event. As a matter of fact, they did not even make it into the top 10 of ETF high-volume days as calculated by Credit Suisse.2 It is estimated that the funds traded roughly 2.5 billion shares, or $146 trillion in notional. The minimum to crack the top 10 would be approximately 3.6 billion shares. When people trade ETFs, they are buying and selling to effect positions they have or want in the markets. If the ETFs didn’t exist, they would be using other vehicles to try to achieve similar exposures.
ETFs do not cause market sell-offs, but they certainly enable investors to have more control over their exposures in a low-cost, transparent, tax-efficient and liquid vehicle. When volatility increases, people use ETFs more for both portfolio protection and for new positioning. This is why volumes in ETFs increase in a manner directly correlated to volatility. I believe ETFs continue to prove themselves as a product innovation useful to a large section of the investment community. The assets in ETFs are a testament to how admirably they have performed through a variety of market environments over the years and I expect they will continue to do so for many more.
David Abner is the Head of Capital Markets at WisdomTree Asset Management. This post was republished with permission from the WisdomTree blog.
1Source: David J. Abner, Visual Guide to ETFs, Bloomberg, 2013.
2Source: Credit Suisse Research Department, Information as of 6/20/2013.