Mechanisms in the ETF market - and possible “surprises”

If demand increases for an ETF above the available supply in the secondary market the Authorized Participant/Liquidity Provider (AP) will buy the basket of the securities underlying the index in the primary market. The AP delivers the shares to the ETF provider and receives in exchange newly created ETF units which are then sold to investors in the secondary market. The opposite takes place if selling exceeds demand from investors by the redeem mechanism. Every time an AP uses the create/redeem mechanism it earns an arbitrage profit. Competition between APs ensures tight bid/ask spreads, and the spread is often the best indicator of the liquidity of an ETF. The create/redeem mechanism ensures the price of an ETF is in line with its underlying net asset value (NAV). Creation and redemption of ETF shares takes place overnight with the ETF provider.

“Surprises” in recent ETF markets

As stated by one of the major ETF providers in one of their ETF descriptions, their ETF “aims to track the performance of the xxx index”, with no guarantee that the ETF will yield the same return as the underlying assets. This difference between the ETF and the underlying index is denoted the “tracking error”, and many investors are not aware that ETFs are not a direct 1:1 replicate of the returns in the underlying benchmark.

These tracking errors may become even worse for ETFs tracking derivatives. The rapid decrease of the oil price – even into negative territory – caused a temporary trading halt in the United States Oil Fund LP ETF. The ETF (which cannot trade at negative prices) were suddenly tracking a derivative asset negative, which forced a change in the tracking rules of the ETF. The creation mechanism was suspended for the ETF, keeping only the redemption possibility. As the synergy between the creation-redemption mechanisms were removed, the authorized participant could no longer benefit from the arbitrage, and this resulted in major tracking errors between the ETF and the underlying assets. At the time of writing, the ETF trades at a premium of more than 36 % from their “fair value”! Investors with interest in buying these new lows should keep these mechanisms in mind before investing.

The examples above show that the price of an ETF does not always reflect the value of the actual underlying assets – especially not for leveraged ETFs. With this being said, ETFs still provide a good opportunity to diversify your portfolio at low costs, keeping in mind the risks associated with trading ETFs. And for ETFs which do not track derivative products, these tracking errors are less pronounced.

The ETF industry was launched in the US in 1993 and initially created for institutional investors demanding an alternative to equity futures which exhibit rolling costs. In the beginning the demand was low, but over the following 10 years the AUM of equity ETFs grew AUM as retail investors also discovered that this new financial instrument offered broad-based access to financial markets at low costs compared to active mutual funds. Especially since the financial crisis ETFs have enjoyed rapid growth in AUM by more than 200 % since 2009 to USD 2.9 trillion in the US with around 80 % tracking equity indices [BlackRock Global ETP Landscape – Industry Highlights (May 2017), BlackRock].