ETFs Aren’t The True Market

July 15, 2013


However, in cases where underlying liquidity is limited, either because of limited access or liquidity—you tend to see these limitations materialize in the premiums and discounts experienced by those trading shares of the ETFs.

For example, let’s look at an ETF such as the Market Vectors Indonesia Small Cap ETF (NYSEArca: IDXJ). The fund has an underlying volume/unit measure of 8.77 percent.

In essence, if I needed an AP to create 100,000 shares of the ETF on my behalf, that creation alone would account for over 17.5 percent of the volume in the underlying securities. Also, consider that only a limited few of the 45 APs have direct access to the Indonesian markets.

Sure, they could opt for a cash creation, but in that process the AP is essentially handing over the buying of those underlying securities to a third party that isn’t primarily concerned with getting the best price for them.

As a result, something like IDXJ can see a significant premium or discount, not simply as a result of stale iNAV or NAV pricing, but also because APs will have to charge a premium for the risk of executing the trades—especially in a situation where’s there’s less competition among market makers due to lack of access.

So how does all this apply to all the problems with exiting fixed-income positions that journalists and bloggers are so worried about?

Interestingly enough, State Street Global Advisors tinkered with aspects of underlying liquidity. A few weeks ago, the firm halted cash redemptions in its fixed-income ETFs. As a result, APs that had to redeem ETFs as they were buying them back in the primary market were given the actual underlying bonds to sell in the secondary markets. That’s a huge burden on the AP.

Not only does the AP have to account for slippage in selling the bonds, but it’s likely the group of APs willing to do such redemptions was smaller than the normal group accustomed to cash creations. As a result, investors saw significant discounts.

However, the benefit of the in-kind redemption process is that investors currently invested in the ETF are protected, while the APs—and consequently those selling the ETF—bear the burden of the exit costs.

The key point here is that ETFs may offer liquidity, but that liquidity often comes at a premium that expands during times of market volatility as a result of issues that begin in the underlying markets.

Also, to believe that ETFs are becoming the true market is an oversimplification.

Unlike futures contracts that can settle in cash, with ETFs, at some point someone has to deal with the liquidity of the underlying markets.

At the time this article was written, the author held no positions in the securities mentioned. Contact Ugo Egbunike at [email protected].


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