November 9, 2011

ETFs and Divine Creation and Redemption

There’s a saying: It’s easier to keep the cat in the bag than to get it back in there once you’ve let it out. Nobody is likely to stuff the Exchange Traded Fund (ETF) cat back in the bag.

Because ETFs are miraculous.

The biblical story of creation is that something came from nothing. Same with the Christian concept of redemption – being bought for a price without rendering equal worth in kind.

Today, we’ll share with occupants of the IR chair the divine story of how ETFs work.

Before ETFs were closed-end mutual funds. Closed end funds (CEFs) are publicly traded securities that IPO to raise capital and pursue a business objective (like any business), in this case an investment thesis. Traded units have a price, and the net asset value rises and falls on the success of managers in achieving objectives. The rub with CEFs is that share value can depart from net asset value – just like stocks often separate from intrinsic business worth.

The investment industry, with support from regulators, devised ETFs to magically remedy through Creation and Redemption this fault of nature. ETF kingpin iShares, owned by Blackrock, illustrates here, with a clever floral analogy (thank you Joe Saluzzi at Themis Trading who alerted us to it). You don’t have to buy individual flowers and face market risks because iShares puts them in a bouquet for you. Great idea.

Now suppose instead of one bouquet you want a thousand? In the market, what happens if someone suddenly wants not a hundred but ten million shares of your stock? Supposing such a trade were even possible today, the impact on your market would be extraordinary. But what if you could instantly issue ten million shares – poof, out of thin air? Your stock price would stay the same, because supply would swell to absorb demand.

That’s what ETFs do. They create shares. They must specify the methodology in their prospectuses. For instance, the iShares Telecom ETF “IYZ” says “Creation Units” are blocks of 50,000 ETF shares that it will issue to certain “authorized participants.” Some are brokers, some institutional investors. In turn, these participants supply the ETF sponsor with the designated set of assets – the mix representing the ETF’s constitution. In the case of IYZ, it approximates the Dow Jones US Telecom Index.

Redemption is the reverse. The ETF sponsor “redeems” shares by taking back units and returning constituent shares. The elemental concepts of supply and demand are neutralized. Prices of components miraculously stay the same even as tens of billions of dollars flow to ETFs. It’s almost…perverse.

The ETF sponsor as God and creator of the ETF charges authorized participants a licensing fee and buyers of ETF shares a management fee. This seems a good business – charging fees both directions while you work your ETFs like bellows.

But there’s more. ETFs can only be created and redeemed in blocks – 50,000 shares in the instance we cited above. Beyond the obvious inclination for brokers and institutions to “manufacture” units of ETFs from discretionary liquidity as a way to offset portfolio risk without paying for it, the arbitrage opportunities around assembling and disassembling Creation Units stagger the imagination.

You can short ETFs. You can buy, sell and short options and futures on the underlying indexes. Buy, sell and short the components of indexes, and of ETFs, and the options on components. You can buy, sell and short ETF options. You could buy, sell and short closely related ETFs and all their components and related derivatives. You can swap them all, spread-trade them, buy, sell and short the volatility among them.

And how about trading ETFs long or short in small increments and then creating or redeeming units inversely in large chunks if you’re an authorized participant? Institutions and brokers are doing this with highly sophisticated algorithms. Software providers like Tethys Technology abound for maximizing outcomes.

The key to this kingdom, this arbitrage nirvana, is that one entity, through creation and redemption, is stable, while all the others vary.

No wonder ETFs are responsible for some 35-40% of daily market volume. No wonder everything is massively correlated. If ETFs drive demand for components, and ETF units expand and contract to stabilize prices, then price movements of individual securities become volatile intraday, yet major measures come rapidly back into correlation.

The problem is apparent: If the medium of exchange adjusts to fit supply and demand, how do you buy value, or growth? Prices revert to the mean, irrespective of value or growth prospects.

Yet value and growth are the pillars of capital-formation.

What’s more, ETFs are one-day life cycles for industries, sectors and groups. They are only truly effective as investment vehicles for a day. What existed yesterday has been redeemed and what will be tomorrow has not yet been created. From air ye came and to air ye shall return.

EDITOR’S NOTE: The same concept backs the “maker-taker” trading model, in which exchanges pay high-frequency traders to swell and fade around supply and demand fluctuations. Create and redeem liquidity to stabilize prices. It’s behind global central banks too: create and redeem currencies to stabilize prices. Eradicate market forces from outcomes. It’s…unnatural. No wonder everybody is looking for a miracle.

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