ETF Basics: ETFs are No More Of A 'Derivative' Than Mutual Funds

Dec 28, 2010

We have noticed that there still seems to be a fair bit of misunderstanding among those new to ETFs. While the structure of ETF's is different than you may be used to  -- it is really not that complex.   

Ignoring leveraged and inverse ETFs --- the vast majority of ETF assets are plain vanilla index funds --- they are not derivatives.  

Some people think that since ETFs are only representing shares -- and that they aren't actually the underlying securities--- this therefore makes an ETF a derivative.   But this is simply not true.    The ETF holds the actual shares it represents just as when you buy a mutual fund, you don't get the shares delievered to you --- you get mutual fund shares that represent the underlying securities.    Clearly everyone should understand that mutual funds are not derivatives.   They are classified by the S.E.C. as investment funds --- which is how the S.E.C. categorizes ETF's as well.

In fact, you could argue ETFs are less of a derivative than a mutual fund as in the ETF process, actual shares are passed for any creation/redemption.    This is not true when buying a mutual fund.   If you send $2,000,000 to a mutual fund, they create shares for your purchase -- but they do not necessarily buy anything with that money --- it could just sit in cash, it depends on the decision of the portfolio managers.   During this process, no exchange is necessarily involved.   You can send your money directly to a mutual fund company and no exchange would ever know the difference. There were some scandals on this topic in the early 2000's that you may remember regarding late-trading and manipulation --- this was only possible because there was little transparency of this off-exchange activity.   

To better understand how simple this really is, below is an image of the basic mechanics.    Note that in reality there are actually custodians, index information providers, authorized participants and market makers involved ----   but those are all peripheral considerations.


Note also that because the shares are created behind the scenes and the shares traded are on an exchange, this opens up a few new markets.   Now you can sell ETFs short and/or you can trade options on these exchange products.   Neither of these are possible when the creation occurs directly to the investor. Even if you never sell short or trade options, this activity is actually good for you --- as all this incremental trading volume created by options participants allows the ETF provider to cycle out lower-cost shares in the tax-free exchange between the exchange and the ETF provider. You can see in the diagram above how this is only possible because the exchange sits BETWEEN you and the fund provider.




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Comments (3) -

Dec 28, 2010 17:09 #


Thanks for all your blog postings. I follow it closely and are very useful.

I have one query for you regarding the above post. Suppose, I execute an order to buy 100,000 shares of IWM (iShares Russell 2000). Does Ishares buy all the shares under Russel 2000 in the proportion it is represented in the index before it delivers my 100,000 shares? What happens when some of the stocks in the index is not very liquid? Will this cause the illiquid stock price to move?

I am just picking IWM here as a random example. Please explain it with any Index ETF.

I greatly appreciate your insight in this regard.


Sumu United States

Dec 28, 2010 18:01 #

100,000 IWM would be $8 million dollars of value.   This size could be done with virtually zero impact.    iShares has an institutional trading support group which works closely with an authorized broker like Goldman Sachs.    They can do pretty big size with almost no impact in terms of a spread.   They actually quote in sizes of $10 and $50 million and at that size you still have a tiny amount of 'impact' (trading costs).    call it a few pennies on average.  

keep in mind that many ETFs have become quite liquid --- so if you are buying 100,000 IWM, you could work the order a bit and the market would just absorb it -- as someone else might be selling and you just cross the trades and the underlying iShares portfolio just remains unchanged.  a creation/redemption might just be unnecessary.

FWIW, iShares isn't an authorized broker --- so it is just providing useful information for the marketplace really.    the authorized participant (Goldman etc) would actually be the one buying/selling the stock.     iShares would receive the stock from Goldman and then it would sit in an account where the cost basis for those shares is kept in their system.    when time comes and there is a redemption, Goldman sells the stocks on the market and then delivers ETF shares back to iShares and iShares does an in-kind transaction and delivers the lowest cost shares in their system back to goldman.  

so bottom-line, the price impact to take a large trade depends on the ETF but all of the primary ETFs can be trade with size for essentially  trivial amounts of 'market impact'.

I don't know all the details on this process --- but I was on the iShares trading floor a few years ago and I can tell you that their internal systems are quite advanced.  

here is a sample report of what iShares shows  --   note the 3rd and 4th columns from the right, you can do $50 million worth of IWM for an estimated cost of 3 basis pts.   at $79, that would be about 2 cents.


Chris United States

Dec 28, 2010 21:34 #

Thanks a lot Chris for your inputs. It was very insightful and helpful.

Sumu United States

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