How do they work - ETFs
TLDR: How do ETFs work, how are they created, traded, rebalanced.
ETF - Exchange Traded Funds have exploded since they have been introduced in the early 90s. They are some of the biggest holders of assets across the spectrum of investment products, be it equities, bonds or commodities. The term now is ETP - Exchange Traded Products - which covers more than equities. But for this “how do they work” article we will focus on equities in general and NIFTY index - Reliance NIFTY BeES ETF in particular.
What is an ETF
An Exchange Traded Fund is a tradable listed fund which replicates the performance of the underlying index that it is tracking. For our case Reliance NIFTY BeES ETF tracks the NSE NIFTY index, which in turn tracks the 50 largest (by market capitalisation) publicly listed companies in India.
The creation of ETF is quite interesting as it was born out of the flash crash of the DOW in Oct 1988. Before ETFs, Futures were the only way to gain exposure to the index which could be traded in the market and a burn on the index futures led to the market crash of 22% on a single day. This led SEC to speculate the need for a product which is both liquid and tradable as a bridge between stocks and index futures.
The SEC post mortem report was the basis of the creation of the index based on S & P 500 as the first ETF in the US market. This whole creation story is a fascinating read.
Creation of ETF
Typically an ETF is created by an Asset Management Company (AMC) or Sponsor who decides the investment objective, index to track (constituents of the ETF), enlist AP (Authorised Participants - large investors and banks) and creates the units in blocks creatively named as creation units. (See what I did there ?)
So for example in our case if Reliance wants to create the NIFTY ETF, they create an ETF with the underlying stocks of the index with a value of say 100 crores with the help of APs.
The creation unit for this ETF is 5000 units or multiples thereof.
Once the ETF is created, the creation units are warehoused with a third party custodian and can be redeemed or created based on the interest from the APs. This not only provides the much needed liquidity for the ETF but also helps ensure the ETF tracks the underlying index closely. How, we will see as below.
Price tracking by arbitrage
ETF NAV price closely tracks the movement of the underlying index by this mechanism of creation and redemption constantly by APs. Let us understand this better with an example.
Reliance NIFTY BeES is currently at 1000 NAV which comprises of all 50 NIFTY constituents.
The price of the index moves based on the underlying value of the stocks that are part of the ETF. But this is still not a perfect system, because there is always some minor differences between the NAV vs the combined value of the underlying stocks in the Index. This is where the big boys like investment banks, institutional investors play in.
Let us assume the market is bullish, but value of ETF lags behind the underlying components.
Then NAV of ETF (ex - 1001) < weighted value of underlying index (ex - 1005)
Then the Investment banks/ Institutional investors will redeem the ETF with the AMC and get the individual stock constituents and make a quick arbitrage profit on the difference in price 1005 - 1001 (less trading costs) ~ 4 profit.
Let us assume the market is bearish, but value of ETF leads the underlying components.
Then NAV of ETF (ex - 994) > weighted value of underlying index (ex - 990)
Then the Investment banks/ Institutional investors will request for creation units of the ETF with the AMC in exchange for cash or underlying stocks and make a quick arbitrage profit on the difference in price 994 - 990 (less trading costs) ~ 4 profit.
This helps keep the price inline by setting the goal post limits on either end of the price range and tracks the ETF to the index.
See this explained with some snazzy graphics in this bloomberg article.
Indices need to be rebalanced on a fairly regular basis because of the vagaries of the market.
Some underperforming companies might get dropped from the index as their market cap falls below the top 50 list
Some other companies see better growth which were previously not part of the index but now rise into the top 50
Scandals or other considerations could also lead to removal of companies from the index
NIFTY is rebalanced on a semi-annual basis
The ETF will also need to do the same to keep it inline with the Index so they can stay current with their investment objective of replicating the index. They will have sell the holdings of the companies that are moving out of the Index and buy the new entrants based on their weightage.
Recent article from money control about possible rebalance on NIFTY, as an example.
Benefits of ETFs
Built in diversification by investing in a basket of stocks
Tradable in the exchange
ETF global size
The global ETF market is estimated to be worth 3 trillion dollars, which is an incredible number. Unlike developed countries, Indian market is still enamoured with actively managed mutual funds and has not caught up fully with the passive investing. So there is not a lot of variety of ETFs other than vanilla Market Cap based ones.
Types of Index replication
So far in this post we only looked at the simplest type of ETFs, where the index is created by full replication by buying the underlying constituent stocks based on their weightage in the index.
But there are other options like
Partial replication - Use representative stocks of the index to replicate, especially when liquidity is a challenge. This holds true for some global ETFs with exposure to multiple country stocks, where full replication is not possible
Derivative based replication - more details here
One contracting party, uncollateralized commitment
More than one contracting party, uncollateralized commitment
One contracting party, overcollateralized commitment
Many ETF AMCs use stock lending as a way to boost their returns. They do state that they only lend to
“good” institutional investors
Always get collateral in return which has “greater value” than what has been lent
Collateral values are “marked to market” on a daily basis
They always do this via third party holdings to “decouple counterparty risk”
I have heard these before and I don’t like the direction ETFs are taken to.
A relatively new flavour of ETFs that are all the buzz now are leveraged ETFs, which trade on derivative products at 3:1 ratio to increase the yield of the investors. I have not bought into this premise and I never will, but if your risk appetite allows to take this level of risk, you can go for it. More details on leveraged ETFs here.
Market Cap replication of ETFs
Given the nature of the vanilla ETFs to follow the underlying weightage of its stock constituents, the biggest companies in the index sway the direction of the index much more than the smaller constituents and by a wide margin.
Also they might be concentrated by a specific industry which adds an inherent over exposure to that industry.
S & P 500’s top 10 companies are heavy of tech with the likes of Apple, Microsoft, Facebook, Amazon, Alphabet taking up 5 slots of the top 10.
The top 10 companies have a total weightage of more than 20% in the index.
Closer to home, things are even worse in case of NIFTY.
Total weightage of top 5 companies in NIFTY = 39.39%
What about the bottom 10 companies?
Total weightage of bottom 10 companies in NIFTY = 5.75%
Nifty movements are simply controlled by the top 5 to 10 companies and the remaining 40 companies in the index hardly make a dent to the price movement.
In conclusion, ETFs clearly fill a market need and are here to stay. I hope there is further prolification of ETFs and index funds in the Indian market. With SEBI introducing TRI based benchmarking and clear segmentation of actively managed mutual funds, fund managers will find it difficult to beat the market. This should lead to further expansion of ETFs and index funds.
What are your thoughts on ETFs? Do you have any further questions on ETFs? Leave your comments below.
Credits - Title image: www.gotcredit.com