Friday, December 10, 2010

ETF Education: Part 2 Lifting the Hood on ETFs

ETF Characteristics

In part one, we reviewed the history of Index tracking, index weighting, and the transformation from Index Mutual Fund to an ETF Index Fund. We also remind investors of a comment concerning the increasing complexity of ETF’s.
In today's blog we will explore ETF’s to see why they exist. The key learning point we are focusing on here is the need to understand that ETFs are built to deliver specific characteristics. It can be more challenging to compare one ETF structure to another if you do not know why it was built a certain way! When we know what characteristics are important to ETF investors we can see how different structures best capture different characteristics that investors seek. We will also get an introduction to the players who make index investing possible.

We will start by looking at ETF characteristics. Contrary to the beliefs of many retail investors, ETF investing is dominated by the big institutional players in the industry. As such an ETF is most often constructed to meet the needs of the institutional investors first. In general, the plain vanilla low cost ETFs based on popular indices were designed for cost conscious institutional investors – the more expensive ETFs were targeted to smaller investors without sufficient dollars to build comparable investment pools at low cost. As an example the XBB although based on a popular index is too expensive for many institutions. They can buy or create cheaper investment pools on their own. This is an example of a characteristic (low fee) being the motivator to build a fund and the absolute cost determining the target market (retail clients). We need to understand why specific ETFs are created and what characteristics are driving their new found popularity. When we know "why" they are being created, we can better understand the different approaches that can be used to structure an ETF.

It is important for retail investors to understand the logic behind ETF construction, because while the large investment managers are extremely qualified to analyse the various security characteristics of an ETF structure, that knowledge is not always obvious to investors nor to the poorly trained front line sales staff (typically your so called advisor). These complex structures then bleed down to retail products which are sold as “ETF Index Funds” with no explanation with respect to the ETF structure. The ETF disclosure/sales material is vague at best and often the product is sold without investors being informed of the different risks and characteristics associated with different structures.

More ETF Basics

While it is always dangerous to issue blanket statements about securities, it is fairly safe to say that most ETF Index funds do have some similar characteristics.

A. The Players:

1- The “creator” of the fund is the company that establishes the fund concept and acquires rights to use the target index from the index owner. S&P for example owns the rights to the S&P500 Index and will issue a license to allow a fund company to create an ETF based on the S&P500 Index.). The creator will issue any required prospectus and get approvals to issue the new securities. As an example Blackrock who own the iShares brand are the “creators” of iShares ETFs. Creators are motivated by gathering large pools of investment dollars and skimming a small peice of revenue from every dollar every year.

2- Market Maker: A market maker, according to an Investopedia definition, is a broker-dealer firm that assumes the risk of holding a certain number of shares of a security in order to ease the process of trading the security.
Market makers are looking for the fastest way to hedge trades, create units, and maximize ETF trading capabilities. When an ETF launches, the lead market maker will typically create the first units, delivering the  shares of an ETF product’s underlying index in exchange for units of the ETF. i.e. the market maker gets 100 units of a new TSX60 ETF in exchange for delivering 100 shares of each stock in the TSX60 to the creator.

Lead "market makers" must stand ready to both buy and sell their products on a continuous basis. They typically hedge all bets and make money on bid and ask spreads. It is desirable to keep the spreads as narrow as possible to prevent hedge funds from exploiting differences between the unit value of the ETF and the value of the underlying shares. This works, in live market conditions, to improve both the liquidity of the ETF and to minimize tracking error.Market makers make their profit on trade volumes.

3-  Advisor/Salespeople: ETFs are marketed to both institutional investors (pension funds, insurance companies, hedge funds etc) and retail investors. The products sold are often identical, but the resources necessary to understand the product varies greatly between the two investor types. The role of sales people is to ensure the playing field is level by doing two things; learning how the product works before selling it, and clearly disclosing how the ETF works, what it costs, and the risks of owning the ETF to investors. Their track record at doing these basic things is dismal to say the least.

B- Dual Liquidity Characteristics of ETFs:

The liquidity of a normal widely held mutual fund or an individual stock security is based strictly upon trade volumes of the fund or security. With an ETF, because it is easy to create or release units on demand, the liquidity restrictions are not solely based on the “ETF unit” liquidity, but also on the liquidity of the underlying securities. This means a new ETF offering on the TSX60 can have high liquidity regardless of trade volumes in the actual ETF units. This is because the TSX60 has high liquidity in the underlying stocks. If I request 50,000 units of a new ETF, the market leader just puts in a request for the shares through computerized trading and issues the 50,000 newly created units within minutes (actually seconds).
CAUTION: While liquidity may appear better in the ETF structure, in actual practice an ETF with low trading volume will tend to have greater tracking error than an ETF with high trading volume even though the liquidity of the underlying securities might be the same. As an example the new and smaller BMO ETF will likely have greater tracking error than the XIU until volumes help the designated market maker to keep the bid and ask spreads narrower.
The one wild card in the liquidity situation , is if the market maker for the ETF abandons the market. The risk is similar for most securities but may be more relevant for ETFs given what happened in the “May 2010 flash crash”. (a story for another blog)

C- Cost Advantage:

 Although some active managed expensive mutual funds are starting to use the term “ETF” in their name to confuse investors; a general advantage of the ETF structure is low cost. This low cost is a significant advantage and thus ETF index funds with higher MERs (expenses) generally are not desirable. ETF Index funds for major Canadian market indices can cost as little as 0.08% annual MER. Typically you will not see any deferred sales fees or trailing commission expenses with an ETF, unlike many high cost mutual funds.

D- Tax Advantage:

Typical ETFs have a more passive approach to investing and thus generate low trade volumes , which then translates to low tax costs. A broad based index ETF would rarely need to add or subtract securities from the underlying basket of securities comprising a unit, since most indices are quite stable. Exceptions would be where mergers eliminate a security or where a security was added or dropped from an index.

E- Tracking Error:

Index funds, whether ETF or mutual funds, attempt to duplicate an index’s performance. In all cases there is likely to be some level of tracking error since the index fund charges an annual expense ratio to cover the cost of maintaining the fund. Also, various structures may be prone to tracking error due to the fact the index fund lags the index when changes are made. An index fund is not generally allowed to make changes prior to the actual index making a change. This allows large investors to "front run" changes to the index which increases tracking error and reduces performance. Another significant cause of tracking error is the ETF structure, so without further ado let’s look at what makes an ETF tick!

So, in summary, in part two we learn:

- ETFs often start life as a specialized product to meet the needs of institutional investors, and then are sold later to retail investors through generally poorly trained advisors(tip; some advisors are ETF specialists and better trained than a typical salesperson on the intricacies of ETFs)

- we now can recognize who the ETF industry players are and how they make their profit from ETFs

- we understand the common characteristics of ETF Index Funds that investors either seek to aquire (low cost, high liquidity, low taxes) or to avoid (tracking error, high bid/ask spreads)

I confess this blog was an added step to my initial ETF education series plan. In preparing the next section on ETF structure, I realized it is easier to understand the "what" of creating an ETF if we better understood the "why" and "who" of  ETFs. Hopefully with this better understanding of the above ETF common characteristics, it will make the next section a little less confusing.

Our next blog, I promise we will get down to the serious business of how ETFs actually work! Part 3 coming very shortly!


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