Exchange-Traded-Fund (ETF) 101: Part III

February 8, 2020

ETFs Market Impact

In view of the fact that ETFs have become unexpectedly saleable with investors, many new funds have been created resulting in low trading volumes. The effect can cause investors not being able to buy and sell shares of a low-volume ETF easily.

Concerns have surfaced about the influence of ETFs on the market and whether demand for these funds can inflate stock values and create fragile bubbles. Some ETFs rely on portfolio models that are untested in different market conditions and can lead to extreme inflows and outflows from the funds, which have a negative impact on market stability. Since the financial crisis, ETFs have played major roles in market flash-crashes and instability. Problems with ETFs were significant factors in the flash crashes and market declines in May 2010, August 2015, and February 2018.

ETF Creation and Redemption

ETFs shares are regulated via a mechanism called ‘Creation and Redemption’. It involves large specialized investors, called authorized participants (APs).

Creation

If an ETF wants to distribute additional shares, the AP buys shares of the stocks from the index and sells or exchanges them to the ETF for new ETF shares at an equal value. In turn, the AP sells the ETF shares in the market for a profit. When an AP sells stocks to an ETF sponsor for a share in the ETF it is called ‘Creation.’

Creation When Shares Trade at a Premium

Imagine an ETF that invests in the stocks of the S&P 500 and has a share price of $101 at the close of the market. If the value of the stocks that the ETF owns was only worth $100 on a per share basis, then the fund’s price of $101 is trading at a premium to the fund’s net asset value (NAV). The NAV is an accounting mechanism that determines the overall value of the assets or stocks in an ETF.

An authorized participant has an incentive to bring the ETF share price back into equilibrium with the fund’s NAV. To do this, the AP will buy shares of the stocks that the ETF wants to hold in its portfolio from the market and sells them to the fund in return for shares of the ETF. In this example, the AP is buying stock on the open market worth $100 per share but getting shares of the ETF that are trading on the open market for $101 per share. This process is called creation and increases the number of ETF shares on the market. If everything else remains the same, increasing the number of shares available on the market will reduce the price of the ETF and bring shares in line with the NAV of the fund.

Redemption

Redemption on the other hand proceeds if the number of ETF shares is reduced. This happens when an AP also buys shares of the ETF on the open market then sells these shares back to the ETF sponsor in exchange for individual stock shares that the AP can sell on the open market.

The total of ‘redemption and creation’ activity is the capacity of demand in the market for whether the ETF is trading at a discount or premium to the value of the fund’s assets.

Redemption When Shares Trade at a Discount

Imagine an ETF that holds the stocks in the Russell 2000 small-cap index and is currently trading for $99 per share. If the value of the stocks the ETF is holding in the fund is worth $100 per share, then the ETF is trading at a discount to NAV.

To bring the ETF’s share price back to its NAV, an AP will buy shares of the ETF on the open market and sell them back to the ETF in return for shares of the underlying stock portfolio. In this example, the AP is able to buy ownership of $100 worth of stock in exchange for ETF shares it bought for $99. This process is called redemption, and it decreases the supply of ETF shares on the market. When the supply of ETF shares is decreased, the price should rise and get closer to its NAV.

ETFs are just one of the investment specialties of Investam HK both locally and globally. We have a wide range of ideas we can propose to set for any investors. For more data and facts you may contact us.

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