Introducing the Intern’s Guide to ETFs
Exchange-traded funds (ETFs) are one of the most successful financial innovations of the last 30 years. Since their launch (in Canada) in 1990, ETFs have proliferated, and their assets have grown around the world.
According to ETFGI, in the U.S., there are now over 2,700 ETFs (right axis, open circles) with assets totaling almost $6.5 trillion (left axis, bars).
Chart 1: ETF asset growth
But first things first: What is an ETF?
Is an ETF a mutual fund or a stock?
An ETF is both!
Almost all are legally structured and managed as a mutual fund, following the rules of the 1940 Act. Like other mutual funds, an ETF is professionally managed and holds a diversified portfolio of stocks. Many (but not all) are also index funds, which means their portfolio managers hold almost all stocks in the index but do very little trading.
But an ETF also has a stock ticker that trades on exchange. Sometimes, they trade a lot. Often without much impact on the underlying stocks. That means one investor can buy the ETF from another without the mutual fund itself needing to invest or divest assets.
So, a key difference between mutual funds and ETFs is the timing of exposure for investors and who does the trading:
- Investors send checks to mutual funds, which are invested by the portfolio manager buying or selling stocks for the portfolio – and the investors get “units” of the fund – at the end-of-day unit price.
- Investors buy and sell ETFs with each other at any time during the day – often without the underlying stocks needing to be bought or sold.
Chart 2: An ETF like the QQQ is a fund that holds the top 100 non-financial stocks on the Nasdaq exchange, in the same weights as the Nasdaq-100® Index (asset weights as of June 28, 2022)
Even though ETF trading may not require the underlying stocks to trade, it is important to investors that the price of the ETF matches the value of the underlying basket. Luckily, ETFs have some unique arbitrage mechanisms that allow market makers to price ETFs very well, which we discuss below.
In addition, ETF portfolio managers build portfolios with returns that almost perfectly match their index performance (Chart 3).
What is Net Asset Value (or NAV)?
It is relatively simple to calculate the value of many ETF portfolios using the live prices coming from the market for each underlying stock. Using that, you can calculate the fund’s portfolio value, then dividing that by the number of outstanding ETF shares gives a “net asset value” for each ETF share trading at the same time. In theory, that’s the price investors should be able to trade the ETF.
Chart 3: ETFs track target portfolios very well
However, NAV isn’t always the price the ETF is trading at. That’s usually because the underlying stocks are not trading at the exact same time as the ETF. In those instances, intraday NAVs are just a guide to the ETFs’ current value. For example:
- Chinese stocks in an ETF listed in the U.S.: The Chinese market is closed when the US ETF ticker starts trading, and the U.S. market closes before all the underlying stocks open for the next day. What you will see is that the U.S. ETF will “price in” new news that has happened since the Chinese market closed.
- Bond ETFs: Bond markets publish no public quotes (or “tapes” of live historic trades) for the underlying bond markets, making it impossible to accurately value the underlying bond portfolio during the day (or sometimes for days).
However, even when those timing differences exist during the day, looking at how the ETFs track their underlying portfolios over longer periods shows that most are likely very fairly valued.
The evolution of ETFs to more active portfolios
ETFs have also matured to offer investors exposure to almost all asset classes, countries, investment styles and market caps.
Early ETFs were exclusively index funds. SPY, the S&P 500 index ETF, was the first to launch in the U.S. It was followed by Select Sector funds like XLE (Energy) and XLK (Technology), which also follow S&P indexes. In the 1990s, there were also tradable country index funds run by banks that became some of the earliest iShares country funds.
However, over time, the SEC has closed the gap between classic end-of-day active funds (like mutual funds and closed-end funds) and the early index-based ETFs, allowing more active stock selection with easy arbitrage mechanisms.
An even more recent change was to allow active semi-transparent portfolios – especially given how important it is to investors for an ETF price to be very close to its NAV value. Having less clarity about what stocks an ETF holds does make arbitrage less certain, but the market worked out a way to do this so market makers can still set tight spreads without incurring losses from mispriced quotes.
These days many ETFs are not market-cap weighted; some are actively picking stocks and may even mirror the portfolios of established active mutual funds. Some of the newest ETFs offer active stock selection and an easy way to invest in some popular themes.
Chart 4: Evolution of different ETFs, as the SEC closed the gap between index ETFs and active mutual funds
ETFs trading: liquidity and spreads
U.S. ETFs are very liquid. They trade over $170 billion every day, which is close to double what the whole European market trades each day. Although we highlight that the U.S. futures markets are even more liquid, trading even more than the underlying U.S. stocks.
However, futures trading is very concentrated in the single S&P 500 exposure, while ETFs allow for a much greater variety of hedges and single trade exposure.
And as the data in Chart 5 shows, trading ETFs is often cheaper than trading the underlying basket of stocks, as the spreads on ETFs are often smaller and cheaper to cross. That’s especially true for the most liquid ETFs, like SPY, QQQ and IWM (bottom right of Chart 5), that trade with spreads less than 1 basis point. Plus, with just one trade required for a basket exposure, they are also cheaper to settle.
Chart 5: Almost all ETFs are cheaper to trade than their stock baskets
So, who does the most ETF trading?
Interestingly, ETFs don’t show up in Mutual Fund 13F holdings much, indicating that mutual funds are not large traders of ETFs.
We know from recent research that retail investors are large ETF buyers, with around 70% of their net buying going into ETFs. However, the same research shows that retail contributes to less than 5% of all trading each day in ETFs.
That means ETFs are likely heavily traded by hedge funds, banks and market makers – that’s a testament to their low trading costs, providing effective hedging of more customized exposures than futures. It is also supported by the fact that the most 100 liquid ETFs make up but 83.5% of all trading, despite being just 3% of all ETFs (larger circles are high and right in Chart 6).
In addition to S&P 500 exposure, this ETF group includes other U.S. exposures like the QQQ and small-cap stocks (IWM), as well as emerging market stocks (EEM) and many sectors like financials (XLF) and technology (XLK).
The data in Chart 6 shows that liquidity is very concentrated, as the largest ETFs by investor assets (large circles) are also mostly the ETFs with the most depth and daily liquidity (top right corner of Chart 6).
Although interestingly, bond ETFs have much more depth than stock ETFs (purple dots are higher in the chart), perhaps a result of lower volatility attracting more market makers to spread capture trades that join the current bid and offer.
That large value available to trade at any instant (depth), combined with the large value trading each day and the tight spreads they have (seen in Chart 5), make these ETFs easy to trade quickly and in large size.
Chart 6: Some ETFs are extremely liquid; others are used more selectively
However, even thinly traded ETFs often trade very efficiently. In fact, in a recent study, we found that many thinly traded ETFs have tight ETF spreads with frequent quote changes to reflect new portfolio valuations, even though they had few (or sometimes no) trades – a sign that the ETF was never mispriced enough to trigger even an arbitrage trade. Plus almost all have at least $10,000 on the bid and offer, enough for an average sized trade.
And it’s these other ETFs that are often more attractive to retail investors for their more selective stock selection.
Importantly, not all U.S. ETFs track U.S. stocks.
Data from FactSet on underlying asset exposures shows that many have no U.S. stock exposure at all. Close to $1 trillion of the total ETF assets offer exposure to international stocks, while over $1 trillion is actually invested in bond portfolios. Investors can also use ETFs as a convenient way to buy commodities and currency exposures (including some currency-hedged equity portfolios) as well as harder-to-access exposures like asset allocation and alternative investments.
Chart 7: ETFs give investors exposure to a variety of asset classes, regions, styles and sectors – in one trade; bond ETFs and overseas stocks each account for over $1 trillion of the assets in ETFs
What keeps ETFs tracking NAV: arbitrage
As we said above, it's important to investors that ETFs represent a fair price for the underlying securities. We see that portfolio managers are good at tracking underlying index performance (Chart 3), but ETFs also need arbitrageurs and market makers to keep ETFs accurately priced.
One important feature that keeps the derivative (in this case, the ETF) and the underlying asset in sync is the ability to arbitrage, combined with the creation and redemption feature.
With futures and options, market makers know that at expiry, their long and short positions will collapse, and profits will be locked in. However, that requires arbitrageurs to hold (sometimes large) positions for weeks or even months. That adds to the financing costs and risks while waiting for expiry, which will be factored into the futures prices. It can also result in persistent premiums or discounts.
All ETFs have a unique mechanism that allows an arbitrageur to lock in profits and reduce their positions any night they choose. It’s known as the creation & redemption mechanism.
But before a market maker builds a hedged position in stocks and ETFs, the ETF has to trade “rich” or “cheap” versus the underlying stock baskets.
In reality, NAV represents the last trade price. But arbitrageurs care about the bid NAV and offer NAV of the portfolio. What we find is that the ETF bid-offer spread is often a fraction of the basket spread (Chart 8).
Chart 8: How arbitrageurs look at ETF valuation
For arbitrage to happen, arbitrageurs need to cross both spreads to lock in both sides of their trade and their profits instantly. That means:
- Creation arbitrage (ETF is rich): When the ETF bid is higher than all the stocks’ offers: Selling the ETF at the bid + buying all the stocks at their offers = profits (at least before settlement and creation costs
- Redemption arbitrage (ETF is cheap): When the ETF offer is lower than all the stocks’ bids: Buying the ETF at the offers + Selling all the stocks at their bids = profits (at least before settlement and creation costs (Chart 9 below)
Chart 9: Arbitrage is triggered when both spreads can be crossed profitably
Once the redemption arbitrage trade above is completed, the arbitrager will be long the ETF and short the basket of stocks. They also have very close to zero net stock exposure and, therefore, market movements won’t change profits, although the cost of borrowing shorted stocks will reduce profit over time.
What keeps ETFs tracking NAV: creation and redemption mechanism
However, ETFs offer arbitrageurs a much cheaper alternative to holding large, hedged positions.
In short, any Authorized Participant (someone approved by the mutual fund manager) can send their ETF back to the ETF manager, and in return, the ETF manager will send them all the underlying stocks in the basket, or vice-versa, any night.
If we start from the arbitrage trade in Chart 9, we can show how this works ahead of trades being settled (Chart 10):
Chart 10: ETF redemption mechanism (three steps to net out your hedged positions)
The hedged position involves a short stock and a long ETF position (Chart 10, step 1)
In a redemption, the arbitrageur gives the long ETF is given back to the ETF manager, and the ETF manager gives them underlying shares from the portfolio in return (step 2). The ETF shares are canceled (outstanding are reduced), offsetting the shrinkage of the ETF portfolio.
When it comes to settlement, DTCC will net the long and short stock positions, requiring no shares to be delivered on either side. This reduces the balance sheet costs of arbitrage to zero and eliminates the need to borrow stock to hold the short position.
However, the arbitrageur does have some additional costs they need to account for that range from almost nothing to thousands of dollars:
- ETF managers charge (usually fixed) costs to do a creation and redemption – designed to offset settlement and custody costs of the ETF portfolio.
- Arbitrageurs might also need to pay custodians for settling each line of their trades.
Redemptions do represent net outflows from the ETF; however, the selling of underlying stocks occurs during the day by the arbitrageur as a result of excess ETF selling – not in the close as for mutual fund withdrawals. In fact, the ETF portfolio manager sees no cashflows and does no trading.
Importantly on this point, a number of studies suggest creations and redemptions add to less than 10% of all ETF trading. Thought of another way – a lot of ETF trading is one ETF buyer trading with an ETF seller.
What is an ETP?
You may have noticed in Chart 1 a small additional category called ETPs, or exchange-traded products.
These are generally products that trade like ETFs and are professionally managed exposures but are not technically 1940 Act mutual funds. That means they aren’t technically ETFs.
Some include bank-issued structures (noted) with total return swaps in whatever asset class is desired, called ETNs. Other tickers represent a portfolio of managed futures, like some tracking commodity prices (like oil: USO). They are generally regulated under the 1933 Securities Act, which regulates new security issuance but not how investments within them are managed.
To keep things simple, experts often use the term ETPs as a larger, more inclusive umbrella term for the whole exchange-traded investment product complex.
Retail investors love ETFs
One of the things we’ve learned from our retail trade tracking is that retail investors are very attracted to ETFs too. In fact, our data suggests over 70% of equities' cumulative net inflows since January 2019 are into ETPs, with an amount of over $265 billion. But remember, just because ETFs are U.S.-listed and stock market traded doesn’t mean investors are buying U.S. stocks. The ETFs retail buy includes emerging markets and bonds as well as small-cap stocks and gold.
Chart 11: Retail love ETFs; data suggest their net inflow has been about $265 billion since 2019
What’s the point: ETFs are good for investors, and they know it
ETFs allow investors to buy diversified and professionally managed exposures to all sorts of assets. Data shows they track underlying portfolios extremely well, thanks to good portfolio management, efficient arbitrage and the creation-redemption mechanism.
Spreads are also generally cheap—often cheaper than buying a basket of underlying stocks. Thanks to an efficient network of market makers.
That makes ETFs a cheap and efficient tool for investors that also minimizes stock-specific risks.
In short, ETFs are good for investors, and they know it.
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Market Infrastructure
Phil Mackintosh
Nasdaq
Phil Mackintosh is Chief Economist and a Senior Vice President at Nasdaq. His team is responsible for a variety of projects and initiatives in the U.S. and Europe to improve market structure, encourage capital formation and enhance trading efficiency.
Read Phil's Bio