ETF Creation And Redemption Models

August 17, 2012

Another example where creations were halted this year, although this happened in an exchange-traded note rather than fund, was in the VelocityShares Daily 2x Vix Short-Term ETN. Credit Suisse, the ETN issuer, decided to halt creations due to internal risk limits being reached. The demand for the ETN stayed high, which caused it to trade at a very large premium. Figure 14 shows that the premium eventually ceased at the end of March, right before creations were permitted again. These two examples show the importance of the creation/redemption process. It could lead to a large(r) tracking error when the process is disturbed.

Figure 14

CONCLUSION

We have seen that the creation/redemption process has a significant impact on the liquidity of ETFs. Costs and the overall efficiency of the process have less impact on the spread when ETFs have natural client flow, i.e. there is sufficient volume in the secondary market for market makers to trade out of a position.

Furthermore, we saw that the creation/redemption process of an ETF (in-specie or cash) does make a significant difference when costs are high. Physical ETFs will typically trade in a wider range around NAV by comparison with swap-based ETFs, but physical ETFs can still have a tighter spread on screen and higher value traded. When an ETF is illiquid the creation/redemption process will be more visible in the spread on screen, since a market maker will have to use the primary market to trade out of the position.

Finally, whilst high creation/redemption costs are definitely a potential concern for investors, not being able to create at all can have even more significant effects on the liquidity and tracking error of ETFs. In those cases, ETFs could potentially trade at a significant premium or discount far from their fair value. This shows that having the option to create/redeem is crucial.

 

Find your next ETF

Reset All