Best Practices in ETF Trading: Understand the Redeeming Qualities

Posted on 08/14/2014

Any commentary regarding the "Do's" and "Don'ts" of ETF trading would be remiss if excluding at least a quick discussion of how ETFs are actually created and redeemed in the real world. This process, after all, is a primary distinguishing characteristic between ETFs, Mutual Funds, Closed-End Funds, etc, and we would argue is the aspect that makes the ETF a truly trans-formative investment structure. In the manner that John Elway might have been a solid professional athlete with the arm of Danny Wuerffel or Chad Pennington, the ETF may have found a place within the investment world without the creation/redemption process that exists today ... but perhaps the world is better off not to have known in both cases. Arm strength undoubtedly proved essential for Elway to become among the best to ever play his position, and the ability for ETF units to be created and redeemed on demand is every bit as essential. The graphic below provides some useful information on how order flow is handled, which is a good starting point for our purposes.



The role of the ETF Market Maker, or "Liquidity Provider," is to facilitate the ETF buy and sell demand that comes through the exchanges. There are ample incentives in place for lead market makers to facilitate tight markets, and their role is essentially to stand ready to provide liquidity on both sides of the market and for the duration of a trading session. When a Market Maker is selling ETFs to the public, which is to say Mr. Jones has entered a buy order, he is then buying the underlying securities in that ETF to hedge his own risk. Or, he is delivering ETF shares out of his own inventory and then covering an offsetting short position in the underlying stocks if it is no longer needed. In a given day where a great deal of new net flow has come into an ETF the market maker might thus be heavily short an ETF as the day progresses, but simultaneously just as long of the underlying stocks that make up that ETF.

When the demand for that ETF reaches the size of a "creation unit," which is generally 50,000 shares, the Market Maker can then put in an order for the creation of a "unit" to his "Authorized Participant." The market maker will simply exchange his "in-kind" portfolio of securities that was used to hedge his own risk for that creation unit of the ETF. The authorized participant is the party that goes to the actual ETF issuer who will create the new ETF shares, and will then deliver those shares to the market maker, relieving his "short" position that was created during the days trading activity. Positions may also be settled at end-of-day NAV as well.

In the case of sell orders being processed, the Market Maker (liquidity provider) is then buying ETFs from the public, and then selling short the basket of underlying securities in that ETF to offset his risk. Upon processing enough sell orders from the investing public to reach a "creation unit", the market maker can submit an order to redeem his accumulated position of 50,000 shares in an ETF. He once again goes through his "authorized participant", who can then redeem the ETF shares with the ETF provider, who provides the "in kind" securities that ultimately go back to the market maker to cover his short commitments that existed on his book.

This is generally how the process works, and what is important to understand is the nature of creations and redemptions being "in kind" transactions and that ETF providers claim to have processes in place to assure that creation units are met with the exchange of "like kind" baskets of shares, and that redemption orders are similarly just an exchange of like assets. This process, we are told, includes assurances that an ETF is never created with borrowed shares, and that borrowed shares of securities are never delivered to a market maker redeeming ETF shares. Can ETFs be sold infinitely short? Only to the extent that the underlying securities of that ETF can be sold infinitely short ... which is to say no. Can an ETF be infinitely bought? Only to the extent that there exists someone willing to sell the underlying securities of that ETF ... which is to say, yes, though price must rise substantially.

A Note Regarding the Occasional Growing Pain - ex. iPath Dow Jones UBS Natural Gas [GAZ]

Of course, there are exceptions to the more typical observation that ETFs are created and redeemed in an extremely orderly fashion on a daily basis. For instance, the iPath Natural Gas ETN [GAZ] went through an extended period of time in which shares traded well "away" from its target index's value. To our knowledge new Creation units are still not currently being made, and haven't been for some time, and as a result this ETN is trading much like a closed-end fund. As a result, the product traded at well over a 100% premium (to NAV) a few years ago, and this can happen again in the future if new demand enters the fund. This should remain a major deterrent for those considering this product today, unless the goal is to capitalize upon a broken structure and price disintermediation.

While this is not typical of exchange traded products, or even of all Natural Gas-related products, we'd be remiss if not to mention that such disconnects can occur. Another example from early in 2011 occurred with ETFs with substantial exposure to Egypt's markets during the period of time that the primary exchanges in Cairo were closed ... for a month! Assets came into those funds, but they could not actually be invested in Egyptian securities as the market was closed. At any rate, if you would like to read more about the circumstances surrounding shares of GAZ , we'd recommend an article from Seeking Alpha or of course the numerous articles from our own archives. What makes the ETF work is the creation & redemption process, and so any disruption is that process is reason enough to step back from a product and seek alternatives.

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