Monday, December 20, 2010

ETF Education Part 3 Construction of an ETF


Review: It is hopefully obvious to those following the recent series of blogs, that ETFs are not quite as simple as we might have believed when they first arrived on the scene. They are like a house in that we look at the furnishings and carpeting to see if we like it, but we rarely check the foundation or the attic to see if it is solid.
We have reviewed how indices were created, how that in turn lead to index mutual funds, and then eventually to ETF Index funds. We noted that the names were often misleading (DJIA for example),that there are differences in how various indices were weighted, and we also looked at who the "players" were in the ETF world. We also looked at several of the common characteristics of ETFs and noted they could be positive (low cost) or negative (tracking error) for investors.
 Now we will dissect some ETF structures to see what we actually own when we buy an ETF. We will look at four common structures that can be used to replicate an index.

1- “Basket of Securities” Structure: Let’s start with a plain vanilla ETF Index Fund. This simplest “open ended structure” is what most people believe they are purchasing when they buy an ETF. In this structure the ETF creators duplicate the performance of an index by actually holding a basket of all the underlying securities through a “designated broker”. As an investor you buy a “unit” from another investor or sell a unit to another investor. The underlying stock is transferred in kind which means no capital gains or trading costs need be incurred with respect to the underlying index components. If you attempted the same trade on your own using, for example, a Dow Jones index of stocks, you would make 30 buys on acquisition of the stocks and 30 sells when you sold out; with each transaction generating a tax event (gain or loss)and brokerage fees. A typical simple ETF structure should be able to closely track an index because it directly owns the index components and thus the index performance, minus fees to maintain the ETF.

2- Representative Bundle Structure: If I want to create a Canadian Fixed Income ETF to track the Dex Bond Universe ( 1,100 bonds at last check), I would need to make an extremely large number of bond purchases to capture the whole index. A significant number of the bonds would be difficult to acquire since they may have been a small issue to begin with. Rather than attempt such a ridiculous approach, a creator can do a statistical measure of the characteristics of the DEX Index. The analysis might look at traits such as average term, duration, yield to maturity, and credit rating of the full universe of bonds. They can then select a smaller number of bonds that, on aggregate, match the characteristics of the full Dex Index. Thus with a basket of 30 or so bonds I can reasonably expect to track the Dex Index performance, at a much lower cost for the unit holders. Of course the risk of the ETF not performing exactly as predicted does exist. When you purchase an ETF Index that uses the “representative bundle” approach you should monitor tracking error closely. It is reasonable to assume that this structure can and should reasonably track the index with minimal risk of performance variance and generally lower costs.

3- Future Contracts: Another way to play the market is to buy a futures contract which promises to deliver the value of the underlying securities at a given time. For example, let’s say a one month future contract on the TSX60 can be purchased on a futures exchange. The contract pledges to pay me the value (or actual shares) of the TSX60 at the end of trading on a specified date. If the index goes up I get the higher value and if the index goes down I receive a lower value. An ETF using the future contract structure, is thus not holding the underlying stocks, but is actually exposed to the “contract” which will fluctuate in value. The future value of a share should not be expected to reflect the “current” value of a share. Markets have expectations for price moves that are reflected in the contract values but not necessarily in the stock’s current price. As well the ETF will need to roll over the contracts as they mature and again will pay for “an expected future price”, not the current price. This roll over process is inefficient and as such this type of structure has a greater risk of tracking error. In fact, the ETF is actually exposed to the futures market, not the index itself. With the increased risk comes a few significant benefits as well.
One benefit of this type of structure is that it allows for increased exposure to commodity markets which are not available as a straight stock strategy. Recently oil has been a commodity that many investors are tracking via an ETF, but corn futures or hog futures are also possible to track when you utilize contracts. At the end of a contract the ETF trades out of the contract so that it does not actually take delivery of the underlying asset. The process has some complexity and contract roll over’s can bring significant tracking errors into the picture. This is especially evident in commodity ETFs. For those wanting more information you can look up the impacts of either contango or backwardation on contract rollovers.

4- Exchange Traded Notes: ETN’s are very similar to future contracts in that the “note” is a promise to deliver a value on a given day. Typically a note is an agreement with a large financial firm such as a bank. The agreement requires the note issuer to pay the note holder a given value on a given day. An Investor could for example sign a note with BNS to deliver the value of the TSX60 on Jan1st of 2012. They would agree to a price and the bank would likely hedge the underlying stocks and make money on a price spread built into the cost of the note. Of course, in the event BNS becomes insolvent before 2012, the investor may face a large loss due to the inherent credit risk of the note holder. Default risk may seem obscure but it is a large part of the reason for the current market crash we are working out way through.On the positive side, ETNs offer a great deal of customization since any agreement can be structured as a note as long as two parties agree to the terms and fees.

The above structures are all in common use today. If you buy an ETF Index Fund you will need to know the structure to know what you are holding (stocks or contracts) and whether or not you are taking on counter party credit risk (notes ). Each structure has its benefits and its drawbacks and you need to understand when you should favour one structure over another.

Proliferation: One of the reasons for the wide variety of structures in the ETF market is because institutional investors are often looking to build securities that offer either exposure or protection from price fluctuations in a specific asset class or commodity. As these products get built they are also offered to retail investors as an ETF they can use for similar exposure or protection. While institutional investors have a very specific requirement to fill a strategic goal, investment sales people often just want to offer something new and flashy for retail investors. A classic example is leveraged ETFs which were sold to unwitting investors by supposed advisors who often had no understanding of how they worked or what risks they exposed investors to. Eventually the industry had to back off leveraged ETFs under a barrage of negative media coverage.

ETF Securities: Below is a list of some of the more common types of ETF Index funds that are common in the market place.

1- Broad Market ETF’s: An ETF that encompasses a significant portion of a large market index is considered to be a broad based ETF. These are the indexes that started the whole indexing phenomenon. In fact, many ETF gurus will tell you that these are the only ETFs a retail investor should purchase. Examples are ETFs tracking the TSX 60 or TSX Composite index, the S&P500 or the Russell 3000. The concept is that with one ETF you gain full market exposure.

2- Sector Indexes: A number of indexes are provided to allow investors to focus on stocks within a specific sector of a market. An example would be Energy ETFs, Technology ETFs, or Financial ETFs. Typically these ETFs follow international guidelines for determining which securities fit in which category of the standard “sectors” . All the sectors added together will form the whole of a broad based index. As such these are often called sub-indexes. In effect this becomes a bet on a single sector outperforming the general market and is useful for traders who use a sector rotation strategy.

3- Style Based ETFs: You can purchase an ETF to allow you to take a bet on one style of investing being more profitable than the whole index. The most common examples are Growth and Value style ETFs. During a bull market where stock prices are rising rapidly you would expect growth stocks to outperform the market. In periods of recovery or market fluctuations you might expect stock selection to favour those who can find under- valued stocks reflected in the Value Index. Similarly you can focus on small cap stocks or dividend paying stocks to outperform the general market or to better match your investment needs.

4- Fixed Income ETFs can also track sub-indexes. Typical sub-indexes would include short term, mid term or long term bond sectors. These can be subdivided again by high, medium, or low credit quality. The fixed income options listed can also focus on government bonds or corporate bonds. As well an ETF can track “real bonds” for inflation protection.

In fact, an ETF Index can be created to track anything from world markets, to African Banks, to Companies that sell mouthwash! The positive is that we get access to cheap fees and strong diversification; the negative is that we have to sort between hundreds of different ETF Index funds.  The key point is that JUST BECAUSE THEY CAN TRACK IT DOES NOT MEAN IT IS WORTH BUYING! As such you can expect to see many new indexes come and go on a regular basis to meet the investment whim of the moment.

So, it has been a longer than normal dialogue for this blog, but there is a lot more to ETFs than meets the eye. If you have gotten this far you can have some confidence that you know more about ETFs than many sales people who sell them and certainly far more than your neighbour who is telling you to buy an ETF to track Outer Mongolian Natural Gas Pipeline Companies! Next blog we will look at some ETF investment strategies! See you in the New Year!

Soismike.........with a special thank you to Ken Hawkins at for his suggestions on how to work my way through this topic.


Weigh House - Neal Chambers said...
This comment has been removed by a blog administrator.
Anonymous said...

Why did you remove the previous comment?

sois mike said...

Anon, I appreciated the comment and made the change. As a general rule I try not to leave comments on that refer to spelling or grammar errors after they are corrected. I try to have the comment section for opinions or additions to the topic of the post.