14 November 2017
To enable investors to buy and sell Exchange Traded Funds (“ETFs”) like shares of any publicly-traded company, an ETF enters into contracts with financial institutions to act as Authorised Participants (“AP”). APs purchase and redeem shares directly with the ETF in large blocks of shares called Creation Units. APs typically sell some, or all their ETF shares on an exchange.
ETFs follow a unique format across: regulatory structure, management style, investment objective and indices tracked. But it is Index construction that essentially defines the process, by portfolio managers creating a portfolio that represents a sort of best fit representative sample of that index.
An ETF may have wide bid-ask spreads depending on a product’s trading volume and market liquidity. An ETF’s market price may also diverge significantly from the underlying value of its portfolio, if, for example, there is a disruption in the share redemption or creation process.
A natural liquidity mismatch emerges when liquid exchange traded funds (ETFs) hold relatively illiquid assets. (1)
Current Situation — ETF : Equity Magnitude
The proliferation of passively managed ETFs facilitates the potential misallocation of equity capital distorted by a concentrated exposure to the underlying security. There are currently more than three times as many equity ETFs and nearly 2.5 times as many equity ETF indexes as the number of large-cap stocks in the U.S. (2)
Furthermore, passive ETFs comprise more than 99% of the entire U.S. ETF arena ($2.6 Tn, as of 2016), (3) indicating the dominant position such passive, index-tracking vehicles have grown in today’s market. (4)
Attempts to Regulate
US regulations presently require the active ETF portfolios to publish their positions on a daily basis, which is impacting equity portfolio managers who are reluctant to disclose due to potential of front-running. Contrastingly to the passive ETF and mutual fund class which publish their holdings on a quarterly basis, up to 60 days in arrears.
A number of firms in recent years have SEC filed exemptive relief to use various proposals to provide less than daily transparency of their underlying actively managed ETF portfolio. (5) One firm proposed to use a blind trust, and another proposed a new vehicle type which would be sold at the closing NAV of the active ETF portfolio plus or minus a negotiated spread.
Whilst a number of arbitrage methods can be discussed, the core issue of friction is in the proliferation of passively managed ETFs that facilitate potential misallocation of capital as ETF investors chase past performance irrespective of a security’s fundamentals.
Active arbitrageurs who exploit these ETF deviations using a pairs trading strategy of selling (buying) the over (under) priced ETF would have earned average annual profits of 6.7% over the 2001 – 2010 period. (6)
Rebalancing and Equity Volatility
Rebalancing is a realignment process of portfolio weightings executed by buying or selling of assets to maintain an original desired level of asset allocation.
Several research papers have found that stocks owned by ETFs exhibit higher levels of risk and cost in the form of volatility, trading costs, an increase in ‘stock return synchronicity’, stock correlation, decline in ‘future earnings response coefficients and decline in the number of analysts covering the firm. One author estimates estimate that an increase of one standard deviation in ETF ownership is associated with an increase of 16% in daily stock volatility. (3)
Advantage to the Fundamentals
There are over 1,400 different ETFs in the US market that track a wide variety of underlying indexes. When any of these underlying indexes change, the corresponding ETFs have to change their holdings to reflect market cap. These thresholding rules is where the problem lies. In an extreme example, if Company X gets $1 larger and moves from being the 501st largest stock to being the 500th largest stock, then the ETFs tracking the S&P 500 are going to suddenly have to build large positions in Company X with minimal tracking error.
Tracking error refers to the difference in the ETFs net asset value (NAV) performance versus the total return of its benchmark index. Depending on the horizon, tracking error can be measured on a daily, monthly, quarterly or annual basis.
Relevant information (stock-specific earnings) is not being incorporated in rebalancing prices, and active managers, including those with fundamental active ETF vehicles, should find possible positions to take advantage of these time-arbitrage opportunities.
The idea that traders might ‘herd’ (Devenow and Welch, 1996) or ‘amplify’ shocks (Veldkamp, 2006) is not new. But, these rebalancing rules can also transmit shocks to completely unrelated corners of the market. This idea is more so.
When writing down models of the ETF market, people usually only think about the first component, by the intrinsic demand that an ETF would have for the stock if it were the only fund in the market, like the SPDR was in the early 1990s. The second component is far more capturing how an ETF’s demand is affected by the decisions of other ETFs. Buying by one ETF leads to additional buying by other ETFs. So when there are more ETFs that might hold a stock, each ETF’s decisions have a smaller effect on the decisions of its peers.
Are ETFs distorting the structure of the equity market and/or the underlying securities?
It is now possible to show that small initial shocks to each ETF’s demand can lead to long rebalancing cascades. (7)
|Source: Chinco, Alex. ‘ETF-Rebalancing Cascades,’ University of Illinois at Urbana-Champaign. 6 April 2016.|
It was possible to show that as the number of funds gets large, the sequence of adjustments converges to a Poisson-distributed Galton-Watson process or laggard in tracking.
ETF assets and related indexes are indicators of an ETF’s performance and should move in unison. If not, there is chaos. Perhaps only if you are an institutional investor would it be possible to take ETF arbitrage advantage. However, it is important to understand how arbitrage helps keep ETF prices in line with their correlating indexes and the equities in the fund.
The unique involvement of an authorised participant (AP) in ETFs creation/redemption process can help reduce tracking error during periods of extreme market volatility.
Generally an indicative net asset value (iNAV) is issued by or on behalf of the ETF at regular periods intra-day. The purpose is to ensure that those market makers or Authorised Participants sell the shares/units of the ETF on the secondary market at bid/offer spreads that are within a few basis points of the most recent iNAV.
Tracking error of the AP is just one of the factors you should consider when evaluating any ETF, and shouldn’t be an automatic disqualifier. ETFs in the corporate bond arena have been a particularly positive innovation that improves price discovery and market liquidity in an otherwise opaque and illiquid bond market. However, the increased liquidity has a cascade concern to market stability and shock transmission.
1 Pan, Kevin and Zeng, Yao, ETF Arbitrage Under Liquidity Mismatch (June 28, 2017). Fourth Annual Conference on Financial Market Regulation. Available at SSRN: https://ssrn.com/abstract=2895478 or http://dx.doi.org/10.2139/ssrn.2895478
2 FactSet, ClearBridge Investments. Data as of March 31, 2017.
3 Israeli, Doron and Lee, Charles M.C. and Sridharan, Suhas A., “Is There a Dark Side to Exchange Traded Funds (ETFs)? An Information Perspective” (2016). Review of Accounting Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2625975
4 Ben-David, Itzhak and Franzoni, Francesco A. and Moussawi, Rabih, “Do ETFs Increase Volatility?” (2017). Charles A. Dice Center Working Paper No. 2011-20. Available at SSRN: https://ssrn.com/abstract=1967599
5 Donahue, Bill. ‘Non-Transparent Active ETFs: Ready or Not?’, PWC Asset & Wealth Management, Asset Management Assurance 17 April 2014.
6 Marshall, Ben R. and Nguyen, Nhut H. and Visaltanachoti, Nuttawat, ETF Arbitrage: Intraday Evidence (November 16, 2010). Available at SSRN: https://ssrn.com/abstract=1709599
7 Chinco, Alex. ‘ETF-Rebalancing Cascades,’ University of Illinois at Urbana-Champaign. 6 April 2016.
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