How ETFs work

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djs051085
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How ETFs work

Post by djs051085 »

My understanding of ETFs is that the purchase of a share is similar to the purchase of the underlying assets that back that ETF, less an expense ratio. Is that correct? I hear the phrase "transfer in kind" with reference to this.

So here is my question:
I buy a share of SPY, the S&P500 ETF. And at the time I purchase that share the S&P500 is comprised of 500 specific companies. In theory, those companies can be removed from the index and replaced, i.e. an index reconstitution. What happens to my SPY share? It should reflect the reconstitution because the ETF is actually an investment in futures contracts? (Is this right?)

I'm interested in the market microstructure of these ETFs. I know they don't operate like mutual funds, which keep a cash reserve for liquidations and have turnover. But, using SPY as an example, the share price is substantially lower than the sum of the share prices of the companies in the S&P 500. So it isn't as though my purchase is going towards buying those 500 companies' stock.

Anyone have any insight?
livesoft
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Re: How ETFs work

Post by livesoft »

I would recommend that you read "The ETF Book" by Rick Ferri if you haven't already. Some of the book is devoted to this kind of stuff.
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ogd
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Re: How ETFs work

Post by ogd »

The simple answers are:
1) SPY share price is roughly the weighted sum of all the shares of the S&P, weighted by market cap and divided by an arbitrary amount to produce a share price that makes it reasonable to trade. It's hard to compute it directly, but on a relative basis it will track the market cap of the S&P very closely.
2) Although the shares are created and destroyed in-kind, the fund does exist as an entity above these baskets. It does trade and it does have expenses on an ongoing basis, not just at purchase time.
3) Your purchase goes towards the creation of a basket of shares, along with many others.

I wouldn't go as far as saying you need to read a book, but you do have some studying to do. It's worth noting that the structure of large ETFs vs mutual funds trading in liquid markets is rather inconsequential and it's not far off to think of an ETF as a mutual fund with different purchase and sale mechanics.
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nisiprius
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Re: How ETFs work

Post by nisiprius »

livesoft wrote:I would recommend that you read "The ETF Book" by Rick Ferri if you haven't already. Some of the book is devoted to this kind of stuff.
+1.
Rick Ferri devotes an early, longish chapter to the nuts and bolts and his writing is wonderfully clear. Unfortunately, even though I felt I understood it at the time, I have no continuing need to understand it so my understanding has faded.

There's also an explanation here.

Even if the effect is similar to buying a basket of stocks, it is still indirect and involves "creation units," and there's no reason why the price of a share should be any particular number. For example, as I write this, Vanguard's S&P 500 ETF, VOO, is 168.90 per share while the grandfather of all ETFs, the SPDR S&P 500, SPY, is 184.26. Arbitrage opportunity... not.

An interesting question: how close are we to the day when it would actually practical, at a reasonable cost, for someone to create a product or brokerage service like Fidelity's "baset trading" that would let take, say, $5,000 and place one single order that automatically buys tiny fractional cap-weighted numbers of shares of all 500 companies in the S&P? Literally buys them in real time. You press "buy" once, and five hundred orders go out to the exchange on your behalf. In 1993, when the SPDR S&P 500 ETF was created, that would have been unthinkable; to make it work, you'd need to be able to order truly arbitrarily small fractions of a share, and the commission on each trade would be pretty low. I see that Interactive Brokers is talking about $0.005 per share, minimum of $1 per order, so I guess it would cost at least $500 to make the trades needed to buy the S&P 500. So I guess prices would need to drop by a factor of 100 to make this reasonable.
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Phineas J. Whoopee
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Re: How ETFs work

Post by Phineas J. Whoopee »

ogd wrote:...
3) Your purchase goes towards the creation of a basket of shares, along with many others.
...
Hi ogd,

At least one of us has misunderstood. It's possible we both have.

An ordinary purchaser of ETF shares does not contribute to the creation of a basket, nor does a seller contribute to its destruction.

For each ETF, a very few institutions, often just one, are Authorized Participants. They have an agreement with the ETF sponsor that they can trade a basket of underlying securities for a Creation Unit of ETF shares, often 50,000; or trade a Creation Unit for the securities. It's only for the Authorized Participants that transactions are in kind.

Why would the Authorized Participant do such a thing? Because the market price of the ETF shares has deviated from the value of the underlying assets enough to create an exploitable arbitrage opportunity. That's the mechanism by which ETF prices fluctuate around the net asset value. If the shares get too cheap, it makes sense to buy them them on the open market and swap them with the sponsor for the assets; if too expensive, best to buy the assets, swap them for the shares, and then sell.

Ordinary buyers and sellers do so among themselves, or from the Authorized Participant when the latter is selling from a new creation unit, or to it when it's buying to destroy one.

The Creation Unit process also gives ETFs their well-known ability to minimize capital gains distributions. When redeeming a unit, the ETF sponsor always trades the lowest-basis assets. Vanguard's patented process has extended that advantage to other share classes of many of its funds.

PJW
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ogd
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Re: How ETFs work

Post by ogd »

PJW: yes, that is my understanding as well. The mechanism for a purchase leading to share creation is indirect and it works through many buyers putting upward pressure on the ETF price until it's worth it for someone to create a unit. The opposite happens when selling. In normal, liquid times this is very seamless and inconsequential (except for the tax accounting), but we have seen it misfire badly during the flash crash and occasionally in the muni market.
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Phineas J. Whoopee
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Re: How ETFs work

Post by Phineas J. Whoopee »

djs051085 wrote:My understanding of ETFs is that the purchase of a share is similar to the purchase of the underlying assets that back that ETF, less an expense ratio. Is that correct? I hear the phrase "transfer in kind" with reference to this.
See also my response to ogd, above. What I'm writing here follows on from that.

Conceptually it is similar, and for most investors that's good enough. With respect to the "less an expense ratio" part, yes, ETFs have them, but it isn't that you're buying the assets less that. ETFs are traded on the open market, and the prices are set by would-be buyers placing limit orders, saying I'll buy, for example, 1000 shares, but only if I can get them for no more than $XXX.xx; and would-be sellers doing the same but saying, I'll only do it if I can get at least $YYY.yy. Forgive me if I'm telling you what you already know. A trade happens when the highest $XXX.xx of any buyer matches the lowest $YYY.yy of any seller. A market order simply says take the highest price you can get (the highest present $XXX.xx), or get me the lowest price available (the lowest $YYY.yy). The difference is the spread, that is, the interval between what the most eager buyer thinks of the value and what the most eager seller thinks. Yes, there is also an ongoing expense ratio, which traders take into account when placing their limit orders. What you're paying is the value plus approximately half the spread, not less the expense ratio.
djs051085 wrote:So here is my question:
I buy a share of SPY, the S&P500 ETF. And at the time I purchase that share the S&P500 is comprised of 500 specific companies.
Yes.
djs051085 wrote:In theory, those companies can be removed from the index and replaced, i.e. an index reconstitution.
Also true.
djs051085 wrote:What happens to my SPY share?
The ETF sponsor sells the old assets and buys the new. Usually changes to the S&P 500, in particular, are only a very few stocks at a time. Sponsors have strategies to avoid front-running costs.
djs051085 wrote:It should reflect the reconstitution because the ETF is actually an investment in futures contracts? (Is this right?)
It depends on the ETF. For large cap ones it's often cheaper for the authorized participants to deal in the actual stocks, but they can also use derivatives. Some ETFs, such as inverse and leveraged ones, exclusively use them.
djs051085 wrote:I'm interested in the market microstructure of these ETFs. I know they don't operate like mutual funds, which keep a cash reserve for liquidations and have turnover. But, using SPY as an example, the share price is substantially lower than the sum of the share prices of the companies in the S&P 500. So it isn't as though my purchase is going towards buying those 500 companies' stock.
As ogd wrote, you shouldn't expect the value of a cap-weighted index like the S&P 500 to be proportional to the sum of the prices of its constituents. That would be a price-weighted, well, not index per se, but average, like the Dow Jones Industrial Average. Equal weighting is something different yet again. You also shouldn't expect that each ETF share represents just one of the lowest-cap underlying shares. Because the index is weighted by market cap, not price, there will be more shares of some companies and fewer of others. Also, because it's only the authorized participants doing the buying and selling of underlying assets, the quantity of them in a creation unit will be sized to make the transaction inexpensive. One share at a time would really add up!
djs051085 wrote:Anyone have any insight?
Insight or otherwise, that's what I know. I hope it's helped.

PJW
jdilla1107
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Re: How ETFs work

Post by jdilla1107 »

nisiprius wrote: An interesting question: how close are we to the day when it would actually practical, at a reasonable cost, for someone to create a product or brokerage service like Fidelity's "baset trading" that would let take, say, $5,000 and place one single order that automatically buys tiny fractional cap-weighted numbers of shares of all 500 companies in the S&P?
This would be great for tax loss harvesting.
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Phineas J. Whoopee
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Re: How ETFs work

Post by Phineas J. Whoopee »

jdilla1107 wrote:
nisiprius wrote: An interesting question: how close are we to the day when it would actually practical, at a reasonable cost, for someone to create a product or brokerage service like Fidelity's "baset trading" that would let take, say, $5,000 and place one single order that automatically buys tiny fractional cap-weighted numbers of shares of all 500 companies in the S&P?
This would be great for tax loss harvesting.
I should say so! You'd want to sell only the tiny fractional shares of the losers, especially the short-term ones.

Come to think of it, bringing tax-loss harvesting into the mix, or using specific identification at all and who wouldn't if it were advantageous as in this instance, would render such a situation the same as personally investing in the whole index but managing each and every single stock; that is, active management done as an individual with respect to at least five hundred separate securities.

That argues against nisi's idea, which I must agree is an "interesting question," as he said.

Thanks, jdilla, for putting it that way. It opens, for me at least, a whole new perspective on disaggregating asset classes. It seems almost as if I should sell CSX's vanity logo pencils at a loss, because once they've been made up who else would be willing to buy them even at the non-personalized wholesale cost, but keep the generic post-it notes because they're up and I don't want to pay capital gains taxes. Think of my price to book ratio!

:happy

PJW
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