4. The Operation and Microstructure of Exchange-Traded Funds

This short description of the ETF launching process focuses mostly on the formal and legal steps related to the creation of an ETF. However, it seems obvious that before starting these activities it is necessary to specify many other relevant and essential issues related to both the product itself (e.g., choosing its objective, investment strategy, methods of management, risk management, etc.) and how it functions (e.g., domicile and jurisdiction, taxation, accounting, auditing, distribution, technology, custody, advisory services, etc.). They are usually similar to those that should be considered when creating any other open-end fund, but there are also some aspects that are specific only to ETFs. They concern, e.g., index licensing, listing platforms, and certain agreements (e.g., with market makers, authorized participants, liquidity providers, index vendors, counterparties (in the case of synthetic ETFs), NAV and iNAV calculation agents, or security borrowers). An interesting analysis of the above issues can be found in Lewellyn (2016).

Murphy (2016) presents a detailed discussion of the costs associated with both the launch of an ETF together with its introduction to the secondary market (including registration costs, costs of legal services, index licensing costs (except self-indexing), seeding costs, and initial ETF listing costs) and its subsequent functioning and maintenance on the listing platform (e.g., annual listing and index fees, marketing costs, audit costs, depositary costs), from the point of view of US ETF market.

The ETF rule is effective since December 23, 2019.

A detailed analysis of seeding ETF is presented by Abner (2016).

The process creating ETF shares will be discussed in detail later.

The rules for admitting securities to trading on the secondary market, including ETF shares, may vary considerably depending on the stock exchange. Detailed guidelines and tips on this matter are usually available on their websites.

For some ETF markets, especially in Europe, the dominant part of secondary trading falls not on the stock exchange, but on the OTC market (for more information, see the ETF liquidity description).

In the case of large stock exchange groups, especially those that operate in various countries and have an international investor base, it is possible to trade ETFs in many currencies—e.g., Euronext supports ETF trading in 20 different currencies (AUD, CAD, CHF, CNY, DKK, EUR, GBP, HKD, HUF, ISK, JPY, MXN, NOK, NZD, PLN, RON, SEK, TRY, USD, ZAR).

Sometimes, this market is called the “underlying market” (see, e.g., BlackRock [2010]). However, this term may be misleading, because it is usually used in reference to market a fund’s underlying assets (more details will be given when discussing the liquidity of ETFs).

It is worth noting that NAV-based trading is different in ETFs that invest domestically or internationally. In the latter case, pricing is usually based on next-day execution. This issue will be discussed in detail later.

This description applies, in particular, to the US market. Regional differences may exist for other ETF markets in some aspects of the creation/redemption process.

Full holdings replication during the creation/redemption process is unfortunately often too unwieldy and cost inefficient. However, Rule 6c-11 adopted by the SEC introduced significant changes in this aspect of the creation/redemption process. To reduce transaction costs and minimize tracking error, some ETF issuers are able to publish a portfolio composition file, which represents only a sample of an ETF’s full holdings that they will accept for creation. Like this, the PCF aims to match an ETFs risk/reward profile. This is important, in particular, for ETFs whose portfolios have thousands of constituents or which track less liquid asset classes, geographic regions, or strategies, thus for a large part of international equity ETFs.

APs can use an internet-based matching platform to advertise buy and sell interest anonymously and execute with other counterparties. Crossing transactions in this manner reduces the need to create and redeem in the primary market (BlackRock 2012a).

The clearing and settlement process of primary market ETF shares, including the specifics of internationally focused ETFs, is a very important issue, but it is not the subject of book. Detailed information on this matter can be found, e.g., in Antoniewicz and Heinrichs (2014).

This characteristic applies, in particular, to the US market. For other markets, the tax aspects of the ETF redemption process may be different.

The four main types of execution styles are: Volume-Weighted Average Price (VWAP, the price weighted by the volume at that time), Time-Weighted Average Price (TWAP, the average price weighted by time), Market On Open (MOO, the price from the opening auction or, when there is no opening auction, the first print of the security), and Market On Close (MOC, the price from the closing auction or, when there is no closing auction, the last print of the security) (BlackRock 2010).

There will be more on the importance of trading hours for international equity ETFs later in this chapter.

More data concerning ETF primary market liquidity will be given later in this chapter.

Depending on the market, such an entity may have different names; in the USA, they are called “authorized participants,” while in other markets terms such as “designated brokers” or “participating dealers” are employed.

It should be emphasized, however, that this term is also used in relation to other entities (described later) whose task is to provide liquidity on the secondary market.

Interestingly, some APs are also registered market makers and provide liquidity on the secondary market, as well. This means that some firms are both an AP and a market maker in a given ETF. However, an AP does not have to be a market maker in a given ETF, nor does a market maker need to be an AP. According to Antoniewicz and Heinrichs (2015), ETFs with more AUM have more APs that are registered market makers than ETFs with fewer AUM. In turn, international and emerging market equity ETFs tend to have more APs that are registered market makers than domestic equity ETFs.

Premiums and discounts in ETF pricing will be explained later in this chapter.

Price discovery is a hallmark of ETFs and describes how these instruments can provide a mechanism for market participants to accurately price assets or markets that otherwise are not trading (e.g., during suspensions of stocks or markets). Thanks to that, ETFs may be the primary, invaluable source of pricing information available to market participants. Price discovery is especially vital for the smaller or less liquid segments of equity domestic markets, foreign equity markets (especially when they are closed), and many corners of the fixed-income market; it can also be useful during flash crashes. Since the late 1990s, single-country ETFs have played an important role in providing both liquidity and price discovery, especially on emerging/frontier markets, e.g., in the Malaysian market during the 1997–1998 Asian financial crisis (iShares MSCI Malaysia ETF), in the Russian market when the two main exchanges (RTS and Micex) were closed in 2008 during the financial crisis (Market Vectors Russia ETF), in the Egyptian market during the Arab Spring in 2011 (Market Vectors Egypt Index ETF), or in the Greek market when it shut downs its stock exchange in 2015 (Global X FTSE Greece 20) (Hill et al. 2015; BlackRock 2019a).

The survey included 15 ETF sponsors that collectively offered two-thirds of the number of ETFs and represented about 90% of the ETF’s total net assets as of November 2014.

It draws on data disclosed by fund companies annually (Form N-CEN), as required by the Securities and Exchange Commission. Completion of the form has been required since June 2018 after the close of an investment company’s fiscal year.

The degree of AP market concentration is quite high, on both the US and European ETF markets. According to the BlackRock study, the top five APs accounted for 65% of all creations and redemptions, while the other 30 APs accounted for the remaining 35% (BlackRock 2019b). Only slightly different results were obtained by the research conducted by the Financial Conduct Authority. It covered the daily creation and redemption of units in a sample that consisted of 257 EU-domiciled ETFs managed by 4 of the largest global issuers, with assets under management of USD 381 billion, and representing about 7% of the global ETF market. The five most active APs accounted for around 75% of the observed primary market volumes and the remaining 25% was spread across 29 APs. The FCA data showed the primary market in ETFs is highly concentrated, especially in typical trading periods. This research revealed also that in times of stress, other APs step into provide alternative liquidity, taking up the extra redemptions and taking a higher than typical proportion of redemption volumes (Aquilina et al. 2019).

Assets of synthetic ETFs include securities contained in the collateral (substitute) basket and derivatives.

Minimum volatility ETFs attempt to reduce exposure to volatility by tracking indexes that aim to provide lower-risk alternatives, investing especially in securities that exhibit relatively low volatility and concentration risk.

Apart from the previously mentioned drawbacks, relying on the NAV for trading may also negatively impact the cost of trading due to factors such as order size, direction of the order, and the market maker’s own position. Additionally, cutoff times for trading ETFs vary per ETF, provider, and custodian, which raises the cost and undermines the efficiency of trading. Finally, NAV trading may also result in settlement issues in countries where negative interest rates are prevalent, such as Japan or some European countries.

This measure is sometimes called also intraday indicative value (IIV), indicative optimized portfolio value (IOPV), or portfolio indicative value (PIV).

In practice, investors often do not have to calculate iNAV on their own, as these data are available on the websites of some professional financial services, stock exchanges, and ETF issuers. Some ETF providers offer their clients the ability to calculate ETFs using special algorithms. For example, in 2019, HSBC launched iNAV algo, which makes it possible to execute ETF trades based on their estimated real-time iNAV and investor trading preferences. The algo has been primarily designed to provide clients with greater price transparency and optionality for ETF trading on exchanges, and to help them decide whether to trade on an exchange, OTC, or via a request-for-quote (RFQ) platform (HSBC 2019).

According to ETF.com (2018), the iNAV measure is inaccurate for 80% of all US ETFs, i.e., ETFs holding securities that do not trade precisely contemporaneously with US equity markets.

As discussed earlier, this shortfall can be mitigated by fair valuation done in-house by market makers, authorized participants, or liquidity providers. They may use a proxy to determine the best estimate of fair value for underlying securities that aren’t currently trading, e.g., futures contracts, options, or depositary receipts, provided, however, that such instruments exist and are effectively valued (which raises doubts in some emerging and frontier markets due to their low liquidity). When neither the underlying market nor a liquid future is available, general practice is to multiply broad index movements (e.g., the S&P 500 index or Euro Stoxx 50 index) with the beta of the broad index to the closed market, in order to estimate where the underlying market would be trading if it were open.

A detailed explanation of the valuation rules and practices in the case of international ETFs (i.e., funds with international constituents) can be found in Abner (2016).

An alternative approach to detecting inefficiencies in ETF pricing was proposed by Petajisto (2017). Instead of comparing ETF prices with NAVs, he measured them relative to the current market prices of a peer group of similar funds. This approach eliminates the problem of stale NAVs.

To help investors quantify the potential underlying liquidity in an ETF, some third-party data providers and exchanges publish an ETF’s implied liquidity figures. They indicate how much of an ETF they can trade on a daily basis without having a price impact on the underlying securities, when looking through the ETF at the liquidity of the underlying securities.

The FTSE Russell country classification will be discussed in detail in Chapter 6.

Market capitalization increased by 148% between 2004 and 2015, from USD 3 trillion to nearly USD 7.5 trillion, while the annual value traded has increased in the same period by 67%, from USD 1.8 trillion to just over USD 3 trillion.

Characteristics and determinants of liquidity in emerging markets are discussed, e.g., in IOSCO (2007) and PwC (2015).

Please note that this metric, as well as other popular turnover measures (such as volume and value traded) or bid-ask spreads, are only a proxy of liquidity, but they are commonly employed due to their simplicity and the ready availability of data.

These activities include mostly promoting the development of a diverse investor base with a focus on attracting local and international institutional investors, including enhancing retail participation, increasing the pool of available securities and associated financial products, and investing in the creation of an enabling market environment through the improvement of trading technology, market and reference data, the implementation of market maker schemes, or developing securities lending and borrowing schemes. Much more information about this can be found in Oliver Wyman and World Federation of Exchanges (2016).

ICI analyzed daily ETF market activity for all ETFs from January 2015 to December 2017 (755 daily observations in the sample).

Vanguard’s research covered the period from October 2012 to September 2015 (daily data).

This is demonstrated, for example, by Euronext data which indicate the increasing number of days on which ETF subscriptions or redemptions were recorded (AMF 2017).

ADV is used by both ETF data providers (e.g., ETFGI) and stock exchanges (e.g., NYSE). However, some entities and researchers have introduced their own, proprietary ETF liquidity measures. For example, Deutsche Boerse employs the Xetra Liquidity Measure (XLM) and the intraday Xetra Liquidity Measure (iXLM). The former measures the average implicit transaction costs (bid-ask spread and market impact) in basis points for a given order size and the latter provides information on how the trading costs of an ETF have developed over the course of the day. In turn, Roncalli and Zheng (2014) proposed both absolute and relative measures of ETF liquidity, i.e., measures which, respectively, do not and do refer to the liquidity of the underlying index.

According to research conducted by Petajisto (2017), the median ADV on the US ETF market was USD 1.2 million in 2014, while in the case of the most active ETF (SPY), it was USD 21 billion.

For example, according to the Euronext analysis conducted in 2015, more than 80% of ETF assets are invested in funds with at least four market makers. The two largest equity ETFs (in asset terms) accept quotes from eight and nine different market makers, respectively (AMF 2017). According to data from the Investment Company Institute (2018), in the USA, ETFs had an average of 17 OLPs, with large differences across classes of ETFs. In Ireland, the majority of equity ETFs have around 32 OLPs (Central Bank of Ireland 2017).

Narrower spreads are not necessarily a result of strong competition among multiple market makers. Some are simply more aggressive than others, regardless of the number of competitors they face.

The bid-ask (offer) spread is the difference between the highest price someone is willing to pay for a given security (the bid) and the lowest price someone is willing to sell that same security for (the ask [offer]). Bid-ask (offer) spreads are commonly quoted as a percentage of the relevant security’s market price.

The main reasons for the relatively negligible share of European markets in global ETF trading are the highly fragmented market, the small share of retail investors, and the decentralized infrastructure (trades are settled on the local central securities depositories [CSDs]). Some of these issues will be discussed in more detail later.

Data providers publish different data on the number of exchanges on which these financial instruments are listed, which is probably due to different approaches in classifying ETFs and other types of ETPs. For example, according to ETFGI (2020), ETFs and ETPs were listed on 70 exchanges in 58 countries at the end of 2019.

For example, in 2016, in the group of the 15 most actively traded instruments on the US stock market, as many as 14 were ETFs (in terms of both volume and turnover value). The most heavily traded ETF was the SPDR S&P 500 ETF Trust (SPY). Its average trading value amounted to USD 19 billion (almost 90 million shares), which was more than five times the second most popular instrument (also an ETF) (Vlastelica 2017). According to Euroclear (2017), in the USA, ETFs regularly make up half or more of the ten most active securities on any given day.

It should be emphasized that these data relate only to the US market and are not necessarily representative of other equity markets, especially less liquid ones. For example, the share of passive investors in Austria’s Vienna Stock Exchange (the ATX Prime market) accounted for 18.3% in 2018 (Wiener Boerse 2019).

ETFGI data show that European ETFs and ETPs were listed on 27 exchanges as of February 2020, while Asia-Pacific (ex-Japan) ETFs and ETPs were listed on 17 exchanges, as of September 2019.

BlackRock distinguishes six different trading venue types in European equity markets: primary exchange (e.g., the LSE), pre-trade transparent Multilateral Trading Facilities (MTFs) (e.g., Turquoise), systematic internalisers (including electronic liquidity providers—e.g., Jane Street), periodic auctions (e.g., CBOE), dark MTFs (e.g., ITG Posit), and dark large-in-scale or conditional venues (e.g., CBOE large-in-scale) (Cohen et al. 2019).

According to Euroclear (2017), retail investors account for around 10–15% of the European ETF market, while in USA, this figure equals about 45%.

It should also be remembered that these costs differ significantly depending on the region (country) in which an invest is made, as well as the market capitalization of companies. Detailed quarterly statistics on trading costs (IS costs, commission costs, and broker costs) in relation to most developed equity markets (USA, UK, Japan, and Canada) and various regions of the world are published by Virtu Financial.

Another factor helping to drive ETF demand on the European ETF market, especially among retail investors, is the development of fractional trading in ETFs. This makes it possible to remove the obstacle of the high price of many ETF units, not only in the case of retail investors, but also advisers who manage model portfolios (more about fractional trading later in this chapter).

This subchapter provides practical guidance for ETF trading in secondary market (especially stock exchanges), which can be useful especially for individual investors. For more detailed criteria addressed to more sophisticated investors and also usable for investing in primary markets, including execution styles, see e.g., Abner (2016), Gastineau (2017), and BlackRock (2010).

Although NBBO quotations represent liquidity (price and size) available from market makers who post quotes through a stock exchange, they do not reflect the full depth of the ETF marketplace (it can be accessed by broker/dealers’ ETF block desks or by placing a limit order that is beyond the NBBO).

This subchapter focuses exclusively on secondary market transactions.

On some exchanges, especially European ones, certain ETFs are traded in several different currencies.

In the case of global or multi-regional equity ETFs, their portfolio constituents can be denominated in several or even a dozen or so currencies.

More information on the practical aspects of neutralizing currency risk in different types of international equity ETFs by investing in currency-hedged ETFs will be presented in subsequent chapters.