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Understanding the Structure of ETFs

Understanding the Structure of ETFs
April 24
22:46 2012

While it’s not necessary to know exactly how ETFs are structured to trade them successfully, a little insight into what lies behind the scenes doesn’t hurt. Understanding the basic nature of ETFs will also help you understand why and how ETFs track closely with the value of the assets that underlie them.

First, there are two key players in ETF creation: the sponsor and the authorized participant. The sponsor is the entity that will manage the ETF (and is the one creating it). The authorized participant is an entity that can actually create the ETF shares and so is normally a specialist, market maker, or institutional investor, though in some cases the sponsor and the authorized participant are the same. (Barclays Bank and Deutsche Bank are good examples of this type of sponsor.)

While ETFs and mutual funds have many similarities, they are constructed differently. A mutual fund pools cash from multiple investors and uses those funds to purchase the appropriate securities to build one or more shares (or portions of shares). An ETF, however, is assembled before any investors purchase shares, and without the use of cash.

What takes place is that the authorized participant borrows the necessary securities, usually from another large institutional investor like a pension fund. The shares are placed in a trust and then bundled into what is called a “creation unit,” composed of anywhere from as few as 10,000 to as many as 600,000 shares (though 50,000 is a common standard). The creation unit is then divided into ETF shares, each of which represents a claim on the securities held in the trust.

Since the ETF shares are what are traded on the market, the securities in the trust essentially sit idle, doing little more than earning dividends (which are passed through to the ETF owners). The trust will also reallocate the underlying securities as necessary in the case of more complex ETFs.

Most ETF trading occurs in the secondary market and involves simple buying and selling of ETF shares. However, it is possible to “redeem” ETF shares if an investor owns enough to form a creation unit. (Obviously, this is a fairly high threshold.) The creation unit is exchanged for the appropriate underlying securities, being destroyed in the process, and the investor can then do what they will with the stocks they now own.

Redemption has distinct tax advantages, because upon redemption the trust normally turns over the shares that have the lowest cost basis. As a result, the overall cost basis of the securities held by the trust increases, which decreases capital gains and the associated tax liability. The redeeming investor is not affected, since their cost basis is whatever they paid for the ETF shares. The net result of all this is that small ETF investors are not impacted from a tax standpoint by the actions of large investors, which is often not the case in mutual funds.

Finally, you should understand the process that keeps ETF prices very close to the prices of the underlying securities: arbitrage. As an example, we’ll consider a hypothetical ETF composed of the stocks of Company A, Company B, and Company C. If Company A stock is worth $4.00, Company B stock is worth $3.00, and Company C stock is worth $5.00, it stands to reason that the ABC ETF should have a share price of $12.00. However, in the course of trading it is natural for the ETF price to move independently of the net asset value. It is actually easy to see how this is true in the real world—the average investor doesn’t have time to calculate the net asset value of an ETF that might contain dozens of different securities and see how that compares to the ETF price.

However, there are certain investors—arbitrageurs—who most definitely do compare the net asset value to the ETF price. If ABC ETF has a net asset value of $12.00 but is trading at $12.05, arbitrageurs will buy up blocks of Company A, B, and C stocks, form creation units, redeem them for ETF shares, and sell those shares on the market at a profit. Conversely, if ABC ETF has a net asset value of $12.00 but is selling for $11.95, arbitrageurs will buy up enough ETF shares to equal a creation unit, exchange that creation unit for the underlying securities, and sell those stocks for a profit. In either case, the buying and selling action of the arbitrageurs serves to pull the ETF price and its net asset value back together.

Hopefully this provides you a good understanding how exactly how ETFs are created and function in the marketplace. Fully-informed investing decisions are, after all, preferable to the alternative.

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