The ETF operating environment
An Exchange Traded Fund (ETF) or ‘tracker’ as it is known in continental Europe is a single share that gives the investor the benefit of exposure to a broad benchmark, sector, country or geographic zone in a single transaction. Essentially ETFs, allow you to enjoy both the flexibility of a stock and the diversification of an index fund. Like the underlying index, the basket of shares normally reflects the specific weights of each of the securities within the index and should closely track its performance.
Despite their phenomenal growth a significant amount of confusion still surrounds the ETF market with many unsure of the specific mechanics and risk associated with ETFs.
Investor’s comments often demonstrate that those who invest in passive vehicles do not always make the association with the underlying index that the fund is replicating. This is more pronounced in non-English speaking markets where mnemonics such as ‘footsie’, are not associated with FTSE, the index calculator that calculates circa 10,000 indices a day or the ‘SPDR’ that has come to be known as ‘SPIDER’ and derives from the Standard & Poor’s family of indices.
One feature of ETFs that requires further explanation is the effects of operating costs on expense ratios, as there seems to be an expectation that all ETFs will be low-cost funds. Many sponsors have found that the unique administrative requirements posed by ETFs require expertise that they do not have in-house. Through the selection of an experienced administrator lower operating costs will be reflected in lower expense ratios and it is these overall expense efficiencies that are perhaps some of the most important features of ETFs.
The proliferation of ETFs in Europe over the last 2 years, has led some to suggest that opportunities for further product development are severely limited. Though growth in terms of number of new ETFs is expected to slow, opportunities for style, socially responsible, active, enhanced, small-cap, mid-cap, fixed income, fund of funds based on ETFs and the development of fee-based managed accounts will continue to provide sponsors and investors with a complimentary range of products in which to diversify their holdings and manage their assets in future. This is even before we consider new markets opening up and regulatory approval being given for the creation, sale and distribution of new and existing ETFs.
The key differences between ETFs and traditional funds
Operationally the main difference over traditional funds is the fact that the administrator can provide what is known as an indicative net asset value (INAV) every fifteen seconds throughout the trading day.
Unlike French, Luxembourg Sicavs or UK unit trusts, ETFs are priced and traded throughout the trading day, which is a significant improvement for investors, as they no longer need to wait until the end of the day to buy and sell the shares as with traditional funds.
The way in which ETF shares find their way to the frontline investor is done so in a highly controlled and cost effective manner. All trading in ETFs, after they have been created and before they are redeemed, is carried out in the secondary market where market makers provide continuous quotes.
All types of investors, whether individuals who place a trade with their broker or large institutional investors, can purchase ETFs via the exchange where they are listed.
Creation and redemption in-kind is an essential feature of all existing ETFs, it puzzles many users of ETFs, not because of its complexity but simply because it is different from some of the procedures used by conventional funds.
The creation and redemption of shares in ETFs is done by means of an ‘investment in-kind’ on the primary market. This unique structure allows ‘Authorised Participants’ (APs), who are typically large financial institutions with seats on one or more exchanges, to subscribe to the ETF.
The creation (or subscription as it is sometimes called), is done by delivering or effectively swapping the shares of the corresponding index in order to receive exchange traded fund shares (also known as index shares) from the ‘ETF sponsor’.
What basically happens is that an AP essentially loans an entire portfolio of shares to the asset manager. The shares are then placed in a fund account and shares in the ETF are created, generally in a creation unit of 50,000 shares.
A key benefit of the in-kind creation and redemption process is that the in-kind distribution of securities does not create a potential tax liability, which could occur if a fund sold securities and delivered cash because of the realised gain or loss to the fund.
Unlike traditional funds, ETF shares are book-entry only securities that behave just like shares thereby eliminating the need for costly transfer agent services.
The transfer agency function is one of the most expensive components of operating a traditional fund and is reflected in their higher expense ratios. The result, is an overall cost reduction for the investor by a minimum of 5 basis points as ETF expenses tend to reflect the cost savings on this function.
Investors in traditional funds are only able to obtain the price as of the close of the market, whereas ETFs are offered throughout the trading day. If the ETF’s price deviates significantly from the NAV of the fund during the trading day, then market makers have the incentive and ability to engage in arbitrage. The competitive nature of market making means that mispricing between the ETF and the NAV is arbitraged quickly away
While a cursory analysis of the creation and settlement of ETF shares may cause one to assume it to be a relatively simple process, the truth is clearing and settlement agents play an integral role in ensuring that shares created in the primary market find their way to the frontline investor in a highly controlled and cost-effective manner.
The complexity arises because it is at this point in the processing model that the ETF changes in a practical way from behaving like a mutual fund to behaving more like a regular share. Therefore, just like any other share, the ETF needs to enlist the services of Europe’s clearing and settlement infrastructure to enable market makers to trade them.
To better understand the details of this process, the following step-by-step overview shows how shares created in the 13 FTSE Global Sector LDRS funds find their way to the secondary market.
In order to disseminate the units throughout the secondary markets on the various exchanges across Europe, a primary settlement agent is chosen (in this case Clearstream Banking in Frankfurt) that has links to all the relevant local clearing agents and acts as a hub to receive newly created shares from the transfer agent and then pass these on to the local exchanges. The ETF obtains access to Clearstream Banking through a Clearstream Participant who must be a custodian bank, in this case, DresdnerBank AG.
As Clearstream Banking requires units to be certificated, a Global Certificate is deposited in the Fund’s account at Dresdner. The global certificate will represent all possible shares in issue, this number changing with each creation and redemption to the fund.
An AP, approaches the fund with an order which will include details of where the participant wants the units deposited.
At the same time, the AP will instruct his custodian bank or clearing agent to deliver a pre-defined basket of underlying securities “free” to the custodian for the ETF.
Upon confirmation of the receipt of the underlying basket of securities for the fund with the custodian bank, the transfer agent is then in a position to issue units of the ETF to the AP. In turn, an instruction is sent to Dresdner to ‘Mark Up’ the Global Certificate with the amount of the subscription together with the local clearing agent details. Dresdner passes this on to Clearstream Banking who, by a book entry process, deposits the units into the AP’s participant account at the local clearing agent for trading in the secondary markets supported by Clearstream.
Redemptions in the primary market follow the same chain of events but the units move up rather than down the chart above.
In order to trade ETF shares on the London Stock Exchange the clearing process is a bit different. In order to trade in the UK, ETF units must be made eligible to enter the Crest settlement system. To do this, a registrar must be selected who is a participating member of Crest in this case Computershare Ireland.
In the UK market it is Computershare’s responsibility to make the instruction to either Clearstream or to Crest to move units to an AP’s local clearing agent accounts.
With the pressure on sponsors to reduce management fees on ETFs to make their products as attractive or more competitive than corresponding products, the economies of scale that can be achieved by outsourcing operations can deliver the operating cost efficiencies to help achieve these goals.
Marc Russell-Jones is vice president and European product manager of Exchange Traded Funds, at the Bank of New York, London