ETF Creation And Redemption Models

August 17, 2012

LIQUIDITY IN THE SECONDARY MARKET

The question here is whether the aforementioned factors influence the spread on screen and/or the quoted size of the ETF. As a measure to describe the influence of market maker behaviour on ETFs, two benchmarks will be used:

  • Tracking error measures the volatility of daily tracking differences between an ETF and its benchmark.
  • Tracking difference is the absolute difference in returns between an ETF and its benchmark.

Both tracking error and tracking difference can be caused by multiple factors, for example:

  • An incomplete basket is used instead of full replication.
  • Management and swap fees.
  • An execution of the basket before the close where it is difficult to trade exactly at the NAV price. The execution can lead to a better or worse result compared with the real fair value of the ETF, which is commonly referred to as slippage. How these costs are passed on to investors depends on whether the NAV is guaranteed (the NAV is not always guaranteed for every ETF; in particular non-guaranteed NAVs may be found in emerging markets). When the NAV is guaranteed and the executed price of the basket is higher than NAV, this cost will be incorporated in the fund, which will hurt all existing holders of the fund. If the NAV is not guaranteed the extra cost will only apply to the investor that is doing the creation.

What is the influence of the minimum creation size? When the minimum basket size is relatively large it will increase the on-screen bid-offer spread of the ETF in the secondary market. This is because the market maker will have to keep a trading position on the book for a longer time if the position is not large enough to trigger a creation or redemption in the ETF, and as a consequence the risk premium and therefore spread will increase. Market makers prefer not to have large positions due to the funding and management fees they have to pay on their inventory, and the correlation risk they are exposed to via the hedge. A high minimum basket size also potentially increases the short-term tracking error of ETFs because it is more difficult to arbitrage away deviations from the NAV. So smaller basket sizes will increase liquidity and decrease tracking error but they are less efficient for the fund. This is mainly the case for physically replicated funds since they will have to buy the underlying securities after a creation.

From a market maker's perspective other factors also have to be taken into consideration. The spread quoted by the market maker in the ETF secondary market, for example on exchanges' order books, represents the cost of the hedge plus the cost of creating/redeeming, the cost of holding the position, trading cost and a risk premium for the market maker. The risk premium will depend on the risk appetite of the market maker and in some cases on correlation risk. If a trade is done when some parts of the underlying market are not open, the market maker will have to deploy a proxy hedge, which will increase the risk premium required.

An example of an ETF where a proxy hedge is necessary is the db x-trackers FTSE Vietnam, the only Vietnam tracker in Europe. Limited foreign investment is possible in Vietnam, which makes it hard to acquire the underlying stocks; therefore from the moment a trade is done intraday till the time of the NAV trade a proxy hedge has to be used. The market maker has the risk that this hedge has a different performance to the ETF and therefore an additional risk premium is visible on top of the creation/redemption cost implicit in the spread. In the case of the db Vietnam, the cost for creating/redeeming is 35 bps for end-clients. As can be seen in Figure 2, the secondary market bid-offer spread in the ETF is wider than this to make up for the correlation risk of the hedge.

Figure 2

 

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