The Soul of an ETF

May 17, 2009 by  
Filed under Commentary, ETFs, Investing 101

What makes an ETF an ETF?  What distinguishes an Exchange-Traded Fund from other investment securities?

When the first US-listed ETF, the SPDR S&P 500 (SPY), arrived on the scene in 1993 it had a number of features setting it apart from every other product that come before it.  Yet in some ways it was quite familiar as well.  The fact that it was a fund consisting of many stocks was nothing new; mutual funds had been around for decades.  The fact that it tracked the S&P 500 index did not make it unique; the Vanguard 500 (VFINX) was launched in 1976.  The fact that it was a fund that traded all day on a stock exchange was also nothing new; closed-end funds had also been around for decades.

So what made this product so special?  What set it apart from everything else?  Two features provided the soul of what was to become the ETF industry:

  1. First, SPY had an Intraday Indicative Value (IIV), sometimes just called the Indicative Value, Underlying Trading Value, or Net Asset Value (NAV). Additionally, this IIV was updated every fifteen seconds while the market was open. For this to be possible, the fund’s holdings have to be 100% transparent because the actual value of the underlying portfolio can be updated only if the actual holdings are fully disclosed.
  2. Second, the first ETF had the ability to create new shares and redeem existing shares through an in-kind exchange process. Since the holdings were known, a large institutional investor (called an Authorized Participant) could put together a basket of stocks that exactly duplicated the ETF’s holdings and exchange these stocks for shares of the ETF (and vice versa).

Now, these two things may not sound like a big deal, but they are.  They are the essence of what makes an ETF an ETF.  The IIV means that traders can determine if the ETF is trading at a fair price any time the market is open. The in-kind exchange process means that the trading price should track the IIV very closely.

This arbitration mechanism is what distinguishes an ETF from a closed-end mutual fund.  If an ETF starts trading at a discount to its NAV, the Authorized Participants have a profit opportunity.  They can step in and buy the ETF on the open market, do an in-kind redemption to receive the underlying shares, and then sell the stock, making a profit on the difference.  The Authorized Participants can repeat this process until the discount disappears.

Likewise, if the ETF is trading at a premium to the IIV, the opposite happens: an Authorized Participant exchanges the underlying stock for shares in the ETF and then sells the ETF at a premium, making a profit on the difference.

This mechanism brings another benefit for all shareholders: in-kind exchanges (and therefore Creations/Redemptions) are not taxable events.  This resolves supply and demand imbalances without impacting existing shareholders – a source of significant investor dissatisfaction with traditional open-end mutual funds.

Closed-end funds are not ETFs because they do not have the ability to create or redeem shares through an in-kind exchange.  As a result, their trading price is often at a large premium or discount to the fund’s NAV.

Intraday Indicative Value and share creation/redemption through in-kind exchanges: two simple concepts, yet when combined they become a powerful force – the soul of an ETF.

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