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Exchange-traded funds work by engaging specialised
intermediaries (so-called "authorised participants" or "APs") to
exchange the shares or bonds in an ETF's underlying index for the
ETF shares themselves. Such "creations" of ETF shares take place in
standardised units, often worth a few million dollars each. When
the AP returns ETF shares to the issuer in the reverse process, a
redemption, he receives the index shares or bonds, leaving him
where he started.
For a liquid equity ETF, the constituents and constituent
weightings of the creation "basket" supplied by the AP to the ETF
issuer are pretty much identical to those of the index itself. Look
into the creation basket of an S&P 500 or Euro STOXX 50 ETF,
and you'd see the index in microcosm, in other words.
But for ETFs tracking less liquid indices or asset classes, the
creation and redemption process has never been that simple.
"When we wanted to create a unit of iShares' MSCI World ETF in
the early 2000s, we had consistent problems delivering the less
liquid 'tail' of index stocks, and this regularly caused the whole
creation process to fail," one former ETF trader told
IndexUniverse.eu on condition of anonymity.
The MSCI World index contains around 6,000 stocks from 24
"The penalty for a failed settlement on a large stock basket was
US$30 per stock, and that's before counting the funding costs for
delayed settlement and potential buy-in penalties levied by
clearing systems. As a result it was extremely expensive to fail an
ETF creation. So we worked with iShares to develop a new
methodology:cash creation," said the trader.
In a cash creation, the AP delivers cash, rather than the index
securities, to the ETF issuer. The task of buying the right index
constituents then becomes the responsibility of the issuer, which
charges APs a variable spread (usually expressed as a percentage of
the fund's net asset value) to cover the costs of acquiring the
necessary stocks or bonds.
As well as being used in the traditional (physically replicated)
ETF model for less-easy-to-track underlying benchmarks, cash
creations (and redemptions) then became the norm for the synthetic
ETFs that boomed in Europe after the mid-2000s.
As a synthetic ETF doesn't actually own the stocks or shares in
the index being tracked (instead, it owns a "substitute basket" of
unrelated securities, or holds collateral under a pledge agreement
with a derivatives counterparty), there's no obvious need for an AP
to supply the index constituents to create a fund unit, and cash
creation is the usual practice for such funds.
But the old model of an AP delivering the index shares or bonds
to the ETF issuer has evolved as well. In so-called "custom" or
"negotiated" basket creations, what the AP actually delivers to the
issuer to obtain fund units is the result of often protracted
discussions between the two parties. Creations may also involve a
mixture of index securities and cash.
And, far from the origins of the like-for-like exchange model
used for the first ETFs, some creation baskets may contain only a
much reduced version of the index, particularly in the market's
less liquid areas.
Creation And Redemption Baskets
The managers of State Street's SPDR US$12 billion Barclays
Capital High-Yield Bond ETF (NYSE Arca:JNK), for example, use
distinct creation and redemption baskets to manage inflows and
outflows , each consisting of only a subset of index names.
"Our portfolio managers use the creation and redemption baskets
to manage the fund's weightings against the index," James Maund, a
New York-based member of State Street's global capital markets
team, told IndexUniverse.eu in a telephone interview. "Each day we
send out a file to APs specifying a list of bonds for fund
creations, typically 40-60 bonds long, and a different list of
similar size for redemptions. The size of the list can vary from
day to day."
The Barclays High Yield Very Liquid index tracked by JNK has a
substantially larger number of constituents, 234 in total. JNK
currently holds 252 bonds, according to the SPDR website.
But, depending on market circumstances, the actual creation and
redemption baskets used by State Street for JNK may be much
smaller, adds Maund.
"The best way of describing the creation and redemption process
is to say that the daily lists we publish act as a kind of "menu"
or a starting point for negotiations between the fund manager and
the fund's APs," Maund told IndexUniverse.eu.
"From the list of 60 bonds the portfolio manager may choose to
bring in, for example, eight bonds to create the fund. We set a
maximum notional value for each bond as part of the creation
basket:for example, half a million dollars each in a typical
creation basket size of US$4 million," Maund explained.
Using creation baskets that are restricted in the number of
securities held and which consist of round-lots of individual
securities, typically half a million or a million dollars in each
name, reflects trading realities in the corporate bond asset class,
says Peter Tchir, founder of FT Market Advisors and a former
investment bank credit trader.
"Unlike in virtually every other market, if you ask for a price
in a smaller trade size in high-yield corporate bonds, the
bid-offer spread increases," Tchir told IndexUniverse.eu.
"So, for example, on a typical bond issue from Chesapeake Energy
), the bid-offer spread on a US$1 million transaction might be 1
percent of par value, but for a smaller order the spread might be 3
percent or more," Tchir explained.
Index Effect Pronounced In Corporate Bond Sector
Concerns over valuation distortions apparently caused by the
growing volume of money in index-tracking funds are not new.
However, the "index effect" of ETFs may be particularly pronounced
in the corporate bond sector.
In a recent research publication ("the ETF Bid") analysts at
Goldman Sachs showed that the performance of the constituents of
JNK's close competitor, iShares' US$16 billion iBoxx $ High Yield
bond fund (NYSE Arca:HYG) has become increasingly detached from
that of the rest of the high-yield bond sector since 2009, as
inflows to the fund have soared.
And in a report published last month, researchers from
BlackRock's investment institute cited evidence from credit trading
platform MarketAxess, showing that in the first quarter of this
year the share of the top 2 percent of investment grade bonds by
volume rose to almost a third of overall corporate bond trading,
while trading in the top quintile of bonds by volume accounted for
93 percent of total corporate bond turnover.
However, says BlackRock, corporate bonds' overall liquidity
continues to suffer as the market's investment bank dealers, the
traditional middlemen of the sector, cut their inventories in
response to increasingly burdensome regulatory and capital
"The [corporate bond market's] liquidity is bunched up in large
new issues," says BlackRock. "Poor liquidity is depressing overall
trading-even as yield-hungry investors bid up prices and companies
take advantage of historic low financing rates by issuing more
The firm is attempting to provide its own solution to the
liquidity problems created by the withdrawal of investment banks
from the corporate bond market, recently testing a new bond trading
platform to allow traders to "cross" orders with each other or to
match trades against BlackRock's own internal order flows.
However, the platform's details remain sketchy, and BlackRock
declined repeated requests from IndexUniverse.eu for an interview
with the firm's head of bond trading, Richard Prager.
Other asset managers may set up a competing version of a
centralised bond trading venue, according to a June report in the
Wall Street Journal
, possibly in conjunction with investment banks.
The increasing concentration of bond trading in a few selected
corporate names may cut both ways. On the one hand, it allows ETF
prices to be set on the basis of the marginal pricing of the most
liquid index securities, permitting secondary market ETF traders to
set wafer-thin bid-offer spreads in funds like HYG and JNK during
an average day's trading.
HYG, for example, often trades in the secondary market with a
bid-offer spread of 1-2 cents on current fund price of around
US$92, compared with an average bid-offer of 100 basis points in
the underlying bonds.
But in a stressed market, the dislocation potential may
increase. State Street told IndexUniverse.eu that while a typical
bond ETF creation or redemption may be the result of a negotiation
with its APs, it has the final say over what comes into or what
goes out of the fund.
An unintended consequence of this may be that, during a period
of rapid redemptions, APs will end up receiving bonds they hadn't
requested, potentially driving ETF secondary market prices down
"If traders suddenly start receiving less liquid bonds from the
ETF, such a scenario would accelerate moves to the downside," says
FT Markets Advisors' Tchir. "Dealers wouldn't have the luxury of
saying to the ETF issuer, 'I don't want to buy these bonds'
Bond ETFs have undoubtedly been a huge success and may even have
transformed the corporate bond markets, in the recent words of
iShares. But it's debatable whether they've done anything to
improve the market's deteriorating underlying liquidity, or whether
they've merely shifted trading activity into a small subset of
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