ETF Question

ShaneMc

Registered User
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I was hoping someone might be able to explain a query I have on the general workigns of ETF's. I have an idea of the workings, hopefully someone can confirm or correct me.

an investor buys/sells the funds just like normal equities through an exchange. The ETF employs market makers to make sure that there is a ready suppy in the market.

My quiestion is if there is large demand for shares does the market maker actually invest into the fund itself and then sell its shares onto the market?

Also the price of an ETF can vary slightly to that of the actual fund is this caused by the market maker?

Thanks
 
Can anyone enlighten me as to how dividends are accounted for in ETFs??

i.e. for say an ISEQ20 ETF, when CRH pays a dividend does the ETF go up to reflect this? and if so how does this work? e.g. if the div is say worth 1% of total ETF aggregate value then does ETF climb 1% and so on???
 
To answer ShaneMc's question, the market maker will take an opposite position in the underlying shares to offset his market risk. e.g The market maker sells 100 ISEQ20 shares and buys the equivalent amount in stock )Elan, CRH, BOI etc.) according to the weightings of the index.The MM has to finance both positions but this is factored into the spread.

It is normally possible for the MM to request the fund manager to convert the underlying shares to ETF shares an vice versa but ther is a fee involved. As a result the market maker will generally only do this when its position is sufficiently large. This would occur in your examle, if there were a lot of buyers of the ETF.

In some cases, it is not possible to convert and in such cases it is possible for the intrinsic value of a fund to be outside a MM's bid and offer

As for dividends, I think witholding tax would apply to dividends so the fund would receive about 80% of the value of dividends. e.g. Fund worth 100 and receives a ividend of 1 from one of the underlying shares. When the share goes ex-dividend the fund will drop by 1 but will receive a diviend of 0.8 after tax. New value of fund is 99.8.
 
If there is a large demand for an ETF the market maker will simply create more. However, they generally do not go out and buy all the stocks in the index at the approriate weights.
When you give your money to an ETF market maker they will use it to buy collateral. This collateral may have no relationship to the index being tracked. For example, a commodity ETF will contain bonds (both Govies and Corporate) and sometimes even stock. The performance of this collateral is swapped out for the performance of the desired exposure. This is done using a swap agreement with a Investment Bank (IB) on the other side, generally settled quarterly with collateral flows ocurring if there's an exposure greater than 10%.
If the market maker defaults you are left with the collateral. This may have no bearing on your desired exposure. However because ETFs are UCITS III compliant the collateral will be somewhat diversified in that it can not conatin more than a 10% exposure to any single security.
 
There is a difference between the market maker and the fund manager. Fund managers, and not the market makers, create new etf shares through buying the underlying, and then supply the new etf shares to the market maker.

When you give your money to an ETF market maker they will use it to buy collateral. This collateral may have no relationship to the index being tracked. For example, a commodity ETF will contain bonds (both Govies and Corporate) and sometimes even stock. The performance of this collateral is swapped out for the performance of the desired exposure. This is done using a swap agreement with a Investment Bank (IB) on the other side, generally settled quarterly with collateral flows ocurring if there's an exposure greater than 10%.

This is not my understanding of how they work. Also, it would be a commodity ETC, or ETN, not an ETF. Different rules apply.
 
The vast majority of ETFs get their exposure synthetically using swaps and do not invest physically in the underlying. These include iShares, EasyETFs, and db X-Trackers. Alot of people don't realise this, even within the finance industry. This is fact.
 
Blackpanda, a few ooints.

Are you sure that the vast majority of ETFs do not invest phsically in the underlying. The last place I worked used to market make in a few ETFs and used the underlying to hedge it out. Granted, the underlyings were generally very liquid and not expensive to trade. If it is true, do you know the reason? I could only understand trading a swap to hedge the ETF if the underlying were difficult to trade or replicate(say due to illiquidity, national laws as in China, or contains non-exchange traded items).

I don't see why any serious market maker would give up most of their profit by going to an investment bank and getting them to price up a swap hedge.

Also, as dunkamania mentions, it is the fund manager who creates (or breaks) shares. However in most cases it is possible to give the basket of underlying shares to the fund manager and request them to be converted into ETF shares. The fund manager will charge a fee to the Market Maker for this facility.

Lastly, the collateral posted against the swap has nothing to do with the investor buying the ETF. If the Market Maker defaults, the Investment bank is entitled to the collateral to cover any losses on the MTM of the Swap. The investor is unaffected as they stilll have their shares in the ETF. The fund manager may seek another company to act as market maker at that point
 
Hi Dubrov,

I'll try to address your points as well as I can:

Are you sure that the vast majority of ETFs do not invest phsically in the underlying. The last place I worked used to market make in a few ETFs and used the underlying to hedge it out. Granted, the underlyings were generally very liquid and not expensive to trade. If it is true, do you know the reason? I could only understand trading a swap to hedge the ETF if the underlying were difficult to trade or replicate(say due to illiquidity, national laws as in China, or contains non-exchange traded items).
I don't see why any serious market maker would give up most of their profit by going to an investment bank and getting them to price up a swap hedge.


Yes I am sure about this. I shouldnt have said that "the ETF market maker will use it (your money) to buy collateral". The thing is they already have it: Market makers have alot of securities on their books (govies, corporate bonds, stocks etc.). Take Barclays (iShares) for example. When an investor purchases an iShare, Barclays will, rather than going out and purchasing the components of the underlying index, put these securities to use. They do this by using them as collateral. So the iShare that was purchased now contains securities (that Barclays already have on their Balance Sheet and are not using) that does not match the required exposure. iShares then use their own swaps desk to swap out this exposure for that which is required by the iShare. This is actually cheaper for Barclays because they put securities that were tying up capital to use. The swaps desk will hedge out the performance it is required to pay using futures or whatever they can (it is actually more likely that an ETF will follow this structure if the underlying market is liquid and there are futures on it). An ETF on the ISEQ for example would just buy the individual shares.


Also, as dunkamania mentions, it is the fund manager who creates (or breaks) shares. However in most cases it is possible to give the basket of underlying shares to the fund manager and request them to be converted into ETF shares. The fund manager will charge a fee to the Market Maker for this facility.

I'm assuming the market maker and the fund manager are the same entity. Perhaps some market makers will provide this service but of course they'll charge a fee for it as they would have to sell the assets and set up the structure as above. If it's the ISEQ index their recieving they'd probably just take these on and not sell them but they'd probably still charge a fee. I'm not sure what your point is or if i'm properly addressing it?? Maybe clarify??

Lastly, the collateral posted against the swap has nothing to do with the investor buying the ETF. If the Market Maker defaults, the Investment bank is entitled to the collateral to cover any losses on the MTM of the Swap. The investor is unaffected as they stilll have their shares in the ETF. The fund manager may seek another company to act as market maker at that point.

When i said "if the market maker defaults you are left with the collateral" i was talking about the collateral in the fund (securities not being used by Barclays) and not the collateral that is posted against the swap. If the market maker defaults yes the IB on the other side of the Swap is entitled to the posted collateral (usually T-Bills or cash) but it is wrong to say the investor is unaffected. They would be left with the underlying collateral in the fund. If this included shares or corporates its value would almost certainly fall significantly on the back of such a default. Again fund manager/market maker... I just see these as the same.


Anyway I hope i've clarified the above somewhat.
 
Cheers for the reply BlackPanda.

I understand that the MM is putting to use assets that may be already on their books but there are plenty of ways to do thi (repos etc.)s. Surely just lending the assets out would yield a bigger return.

CAn you give an example of a specific ETF that is hedged out using swaps? I am just interested to see what the unerlyings are
 
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