Structuring of Exchange Traded Funds

Written by Kaushik Sanghani (kaushik.sanghani@xumitcapital.com)

“There is no innovation and creativity without failure” — Brene Brown

The first ETF, NIFTYBEES, was launched in India in December 2001, and now India has more than one hundred ETFs, including equity, debt, gold and other schemes. The asset base of ETFs surged from Rs. 52,368 crore to Rs. 4.99 lakh crore as on March 2022, indicating an annualized growth rate of 57%, as per the release. The growing asset base suggests that people prefer passive investing rather than active mutual funds.

ETFs are self-explanatory. We can trade a particular fund on exchanges. For example, if you want to buy a NIFTYBEES, which tracks NIFTY 50, you can buy from NSE/BSE similar to buying Reliance share during trading hours. This explanation is enough if you wish to invest in any ETFs. But, if we want to understand how any ETFs work, we must spend some time understanding them. This article will help you with that. In this article, we will discuss how ETFs came into existence, the drawbacks or failures of mutual funds, how primary and secondary markets work in ETFs, how liquidity is created etc.

Before learning, it is necessary to understand the problem with the structure of mutual funds. Mutual funds have been around since the 1920s. In a very simplistic manner, a mutual fund is just a pool of money which is contributed by investors and managed by experts from fund houses to get a return on invested capital. This return is shared among investors as per the NAV they have in the fund. Most mutual funds are open-ended and have no secondary market. So if you want to sell the mutual fund, then you have to do it by the fund house only, which takes one to two days. These things are not that much of an issue for investors, but mutual funds have two structural problems.

  1. Free Liquidity Problem

Tax Efficiency Problem:

In a mutual fund, the manager must decide when to buy and sell a particular security. Fund managers face the dilemma of realizing gains and distributing capital gains when the portfolio value increases or holding overvalued securities to avoid realizing capital gains. By selling the overvalued securities, long-term investors are forced to pay tax on capital gains, or if they do so, then short-term investors will not get efficient returns.

Free Liquidity Ratio:

To understand this problem, let’s start with a simplified example. On day one, three individual investors invest one million INR each in a mutual fund. After ten days, one investor decides to redeem their investment.

So what should happen in an ideal scenario?

If we assume the transaction charge as ten basis points, then the total cost will be (1M + gains) * 0.001 = 1000 INR

So the investor who wants to redeem their investment should get (1M + gains) — 1000 INR

But what is happening in real life?

The total charge of the 1000 INR is distributed among all the investors, so in our case, the person who is redeeming will get (1M + gains) — 333.33 INR because the fund manager will have to sell the security and because it’s a pool of money, so the fund will bear this cost of liquidity. Over time, these costs create a massive drag on returns.

Prof. Nils Hakansson has raised all these issues in his paper, The Purchasing Power Fund: A New Kind of Financial Intermediary (1979). After 14 years from these, paper commodity trader Nathan Most launched “Spiders” in 1993. Since then, the ETF market has grown tremendously, having an asset base of $5.75 trillion.

There were all about problems, but now let’s look at the solution. That means let’s understand how ETFs differ from traditional mutual funds and how it works.

Note: All the ETFs track indexes, so it’s a passive investment tool, so any research of market ups and downs are not required from the fund house. Here we will mainly talk about equity ETFs. If we understand this clearly, then understanding others is relatively easy.

ETFs have two markets.

  1. Secondary Market

Primary Market:

Now there are two parties involved in the primary ETFs market. For example in:

(1) Fund House: The entity that runs the fund.

(2) Authorized Participants: Investment banks, big financial institutions and HFTs (High-Frequency Trading firms).

Now let’s understand how an ETF is created. The first authorized participant will buy a basket of stocks predefined by the fund house (all these processes are dynamic and automated), including the cash component described in the above figure. We will see later why the cash component is needed, but before that, let’s follow the process. After creating this basket, authorized participants can give this basket to the fund house in exchange for a creation unit. These creation units are ETFs (In our example, one creation unit = 10,000 ETF shares). Now this authorized participant can sell these ETFs to any specific investors or in the secondary market (Retail investors can buy from here.) Authorized participants trade these ETFs to make money by market-making in the secondary market or arbitrage arising between the primary and secondary markets.

And if the authorized party does the reverse process (going back from an ETF to a basket of stocks) by selling creation units to the fund house.

Now let’s understand why cash components are needed. As mentioned in the above note, ETFs track indices and the constituents of indices change over time, so an additional cash component is required to adjust as per the indices.

The price of one ETF in the primary market is called iNAV, which changes in real time with the market.

Secondary Market:

Understanding the secondary market of ETFs from the above figure and our understanding of the trading market is intuitive. Retailers buy and sell ETFs per their investing and trading activities, while the AP/Market Maker provides liquidity and takes advantage of arbitrage between primary and secondary markets.

How do ETFs solve the problems of a mutual fund?

Tax Efficiency Ratio: ETFs track indexes, so there is no dilemma for a fund manager to choose between the interest of short-term and long-term investors.

Free Liquidity Ratio: In the primary market of ETF, Authorized Participants can buy or sell creation units in integers. (0.5 unit is not possible) So all the liquidity costs are passed onto the redeemer of the creation unit.

In this article, we have understood how ETFs came into existence, what problems they solve and how they work. In the western world, ETFs have grown so much, but in India, we still have much growth ahead. We have yet to discuss any statistics and numbers regarding ETF growth in the world and India, so this will continue in this article. Till then, stay tuned.

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Xumit Capital is a boutique investment advisory firm that deals in equity, global & crypto portfolios and investment migration programs.