Exchange-traded funds (ETFs) can be traded in a variety of ways. At first glance, striking a deal in an ETF at the fund's end-of-day net asset value (NAV) seems quite different from trading at an intraday "risk" price with a market maker. However, the opposite is true and the two methods of execution are in fact closely connected. This is because an intraday risk price directly reflects the mechanism of trading the ETF at its net asset value in the primary market. Normally, if a market maker has sold ETF shares intraday, they will create the shares in the primary market in order to deliver them to the buyer. The market maker is therefore bridging the gap between the investor's wish to trade intraday and the opportunity to trade with the fund in the primary market. The primary market set-up therefore has a direct impact on the liquidity in the secondary market.
In this article we will investigate the different primary market models for ETFs and the way in which these models influence the secondary market. We will compare ETFs with different creation/redemption models and see how these models affect their liquidity. In addition, we will take a look at the extent to which tracking error is related to the primary market model of an ETF.
Let's begin with a quick reminder of the basics of the creation/redemption process for an exchange-traded fund. Only an Authorised Participant ("AP") is able to create/redeem ETFs directly with the ETF provider, either by paying cash or by delivering the underlying securities of the ETF, depending on what the ETF provider allows. An order placed by an AP with the issuer could be the result of client order flow or the desire of the AP to exploit an arbitrage opportunity. The creation/redemption process is the key for an efficient market, since market makers will arbitrage away any inefficiencies in the pricing of the ETF. They are able to do that because they can always create or redeem additional shares.
The ETF creation/redemption process, which takes place overnight, enables market makers to provide liquidity intraday. But since it is not possible to create ETF units during the day, the market maker will require a risk premium to cover the risk of holding a position in an ETF. When a trade is done intraday a market maker will immediately hedge his exposure, and this hedge will be unwound at the end of the day when the NAV trade takes place. After this, whatever remains of the risk premium will be the reward left for the market maker. If the market maker makes a mistake in calculating the risk premium, this could result in a loss on the trade.
An advantage for investors of NAV trading is transparency: the investor will know exactly how much he pays on top of the NAV (typically in the form of a basis point spread, which varies from fund to fund). The NAV always corresponds with the value of the underlying stocks, while this might not be the case with the price quoted for the ETF during the day.
In order to describe funds' creation/redemption models we first need to differentiate between the two most commonly used ETF structures: physically replicated ETFs and swap-based ETFs.
- Physically replicated ETFs hold the securities in the index underlying the ETF. This does not necessarily mean that all constituents are held in the fund; sometimes an optimisation approach is used, where not all securities are purchased but only an optimised subset of them. For example, some emerging markets have holding limits on stocks or bonds that prohibit a fund from buying those instruments. Another example is where the ETF issuer decides to make a trade-off between tracking error and tradeability of the fund. The more constituents of a fund, the more expensive it can be to create/redeem.
- Swap-based ETFs can hold a form of collateral that might be unrelated to the ETF basket. Through the swap, the performance of the index (minus a fee) tracked by the ETF is exchanged for the performance of the basket.