Mechanisms in the ETF market - and possible “surprises”

Peter Garnry

Head of Equity Strategy

Summary:  Many market participants with exposure in exchange traded funds (ETFs) tracking oil futures have been surprised by recent events - with yesterday's temporary trading halt in a major ETF tracking US oil futures as the latest. For traders with interest in ETFs it is important to understand the underlying mechanisms - especially for ETFs tracking derivatives.


An ETF is an investment fund traded on stock exchange or other trading facility much like a common stock. In general ETFs offer diversified exposure to financial markets at lower costs than traditional alternatives such as mutual funds. ETFs are issued by an ETF provider to an authorized participant (AP) which then facilitates trading as market makers to the public. The original ETFs, and also the largest today, track an underlying benchmark index such as the S&P 500 Index holding a basket of securities closely matching the underlying benchmark weights. Many of these ETFs are using physical replication which means that the ETF provider owns the underlying physical assets. Newer ETFs track derivative products such as VIX index derivatives or futures contracts, and some ETFs even apply leveraging and inverse payoffs of the underlying benchmark.

Structure of the ETF market

The ETF market is split into a primary and a secondary market, as illustrated in the figure below:

  • The secondary market consists of the natural ETF trading between buyers and sellers either on an exchange or in the OTC market (often a request-for-quote market). Typically an ETF is traded on multiple exchanges as with stocks.

  • The primary market is the most important part of the ETF ecosystem and is the primary source for determining the ETF liquidity. This is regulated through the creation of new ETF units or the redemption of existing ETF units, depending on the supply/demand in the secondary market.
Source: Mackenzie Investments

If demand increases for an ETF above the available supply in the secondary market the Authorized Participant/Liquidity Provider (AP) will buy the basket of the securities underlying the index in the primary market. The AP delivers the shares to the ETF provider and receives in exchange newly created ETF units which are then sold to investors in the secondary market. The opposite takes place if selling exceeds demand from investors by the redeem mechanism. Every time an AP uses the create/redeem mechanism it earns an arbitrage profit. Competition between APs ensures tight bid/ask spreads, and the spread is often the best indicator of the liquidity of an ETF. The create/redeem mechanism ensures the price of an ETF is in line with its underlying net asset value (NAV). Creation and redemption of ETF shares takes place overnight with the ETF provider.

“Surprises” in recent ETF markets

As stated by one of the major ETF providers in one of their ETF descriptions, their ETF “aims to track the performance of the xxx index”, with no guarantee that the ETF will yield the same return as the underlying assets. This difference between the ETF and the underlying index is denoted the “tracking error”, and many investors are not aware that ETFs are not a direct 1:1 replicate of the returns in the underlying benchmark.

In the volatile markets in March, where liquidity disappeared in many European ETFs, market makers spreads widened dramatically. As an example, the average bid-ask spread in percentage terms peaked during the month at 3.1% for an ETF tracking inflation-linked government bonds. The tracking error during this period increased significantly, and the ETF traded with a 4 % discount to the actual value of the underlying assets. In some cases with ETFs tracking corporate bonds the ETF price may go well below the fund’s net asset value because the underlying prices on the corporate bonds are uncertain or maybe rarely updated.
Source: Bloomberg - Inflation-linked ETF from Xtrackers. Top: Price of the ETF (white) compared the net value of the underlying assets (blue). Bottom: Premium of ETF compared to benchmark.

These tracking errors may become even worse for ETFs tracking derivatives. The rapid decrease of the oil price – even into negative territory – caused a temporary trading halt in the United States Oil Fund LP ETF. The ETF (which cannot trade at negative prices) were suddenly tracking a derivative asset negative, which forced a change in the tracking rules of the ETF. The creation mechanism was suspended for the ETF, keeping only the redemption possibility. As the synergy between the creation-redemption mechanisms were removed, the authorized participant could no longer benefit from the arbitrage, and this resulted in major tracking errors between the ETF and the underlying assets. At the time of writing, the ETF trades at a premium of more than 36 % from their “fair value”! Investors with interest in buying these new lows should keep these mechanisms in mind before investing.

Source: Bloomberg – United States Oil Fund LP. Top: Price of the ETF (white) compared the net value of the underlying assets (blue). Bottom: Premium of ETF compared to benchmark.

The examples above show that the price of an ETF does not always reflect the value of the actual underlying assets – especially not for leveraged ETFs. With this being said, ETFs still provide a good opportunity to diversify your portfolio at low costs, keeping in mind the risks associated with trading ETFs. And for ETFs which do not track derivative products, these tracking errors are less pronounced.

The ETF industry was launched in the US in 1993 and initially created for institutional investors demanding an alternative to equity futures which exhibit rolling costs. In the beginning the demand was low, but over the following 10 years the AUM of equity ETFs grew AUM as retail investors also discovered that this new financial instrument offered broad-based access to financial markets at low costs compared to active mutual funds. Especially since the financial crisis ETFs have enjoyed rapid growth in AUM by more than 200 % since 2009 to USD 2.9 trillion in the US with around 80 % tracking equity indices [BlackRock Global ETP Landscape – Industry Highlights (May 2017), BlackRock].

Disclaimer

Saxo Capital Markets (Australia) Pty Ltd prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Combined Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Pty Ltd ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide and Product Disclosure Statement to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products such as CFDs and Margin FX products may result in your losses surpassing your initial deposits. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.
Please click here to view our full disclaimer.