ETFs: liquid engineering

As part of a series of articles delving into some of the areas of ETFs which regulators have examined, Nick Sudbury looks at the mechanics of how ETFs trade

ETFs are deceptively simple investments that perform like an index tracking fund while trading like a share. This attractive combination has led the ETF market to grow to AUM of almost $1.5trn. 

The rapid development of the industry has raised a number of concerns that are currently being assessed by the various regulatory bodies. But investors need not be unduly alarmed as long as they fully evaluate the risks and examine how these products work. 

 

Core process 
ETFs operate in both a primary and a secondary market, a process which starts with the issuer, which is the firm responsible for the management of the ETF and the underlying securities. One of their key roles is to publish the list of constituent assets at the start of every trading day. 

This data is used by the Authorised Participants (APs), which are large financial institutions that operate alongside the issuer in the primary market. They have a contractual obligation to create or redeem units in the ETF to meet the supply and demand from investors. 

APs create ETFs by making an in specie transfer of the underlying securities to the issuer in return for new units. These assets are then held by an independent custodian. In some cases they can also do this by delivering cash, which the issuer then invests accordingly. The redemption process is the exact opposite, with the APs exchanging the ETF units for cash or blocks of the underlying securities. 

There is a growing trend to limit the creation/redemption process to cash and to reduce the number of APs covering a particular ETF. This has the advantage from the issuer’s perspective of helping them to keep the trading profits from the underlying securities in-house. Those ETFs that have gone down this route have typically seen a reduction in their AUM, whereas the more open alternatives have tended to see their assets grow. 

Matt Holden, head of ETF trading at Knight says that those ETFs where the APs can only create/redeem units in cash have been problematic during the recent market volatility.

“This has not been the case with those where the APs have the flexibility to create/redeem units in cash or in specie. The only issue with these is where liquidity is a problem in the underlying holdings.”