Today we switch to an important part of the stock market ecosystem: Exchange-traded funds (ETFs).
ETFs are one of the most successful financial innovations of the last 30 years. Since their launch (in Canada) in 1990, ETFs have proliferated and their assets have grown around the world. According to ETFGI, in the U.S., there are now almost 3,500 ETFs (right axis, open circles) with assets totaling around $9 trillion (left axis, bars).
Chart 1: ETF asset growth from 2003 to June 2024
What is an ETF?
An ETF is both a mutual fund and a stock!
So, when you see an ETF ticker, like QQQ for the Nasdaq-100 ETF, remember it represents a managed portfolio of securities, as well as a stock you can trade yourself.
Chart 2: An ETF like the QQQ is a fund that holds the top 100 non-financial stocks on the Nasdaq exchange, in the same weights as the Nasdaq-100 Index® (asset weights as of June 6, 2024)
Most ETFs are legally structured and managed as a mutual fund, following the rules of the 1940 Act. Like other mutual funds, an ETF is a professionally managed portfolio that holds a diversified group of stocks. Many (but not all) are also index funds, which means their portfolio managers hold almost all stocks in the index but do very little trading.
A key difference between mutual funds and ETFs is when and how an investor buys the fund:
- For mutual funds, investors send checks to the asset manager, which are invested by the portfolio manager at the end of the day. The investors get “units” of the fund at the end-of-day unit price, which is calculated from the “net asset value” of the fund.
- ETFs, meanwhile, trade all day on a stock market, just like a stock. That lets investors buy and sell the ETF at the current market price – often without the underlying stocks needing to be bought or sold. That also means each ETF has a stock ticker with bids, offers and trades. Importantly, at the end of each day, arbitrageurs can do creations and redemptions of ETF shares, which is how the fund receives net investments over the day.
In order for ETFs to be created and redeemed every day, the U.S. Securities and Exchange Commission (SEC) has specific exemptions from the trading rules in the Exchange Act of 1934. Some of the trading rules were designed to apply to companies, like rules around new share issues and accounting data when a company raises new cash raises. Exemptions from these allow the ETF to “issue new shares” any day they need.
What is an ETP?
Some of you may have noticed in Chart 1 a small additional category called “ETPs” and wondered what that was.
- ETP stands for exchange-traded product. It is usually used as a more inclusive umbrella term that includes all exchange-traded securities that allow creations and redemptions, and therefore arbitrage. For the most part: ETPs = ETFs + ETNs.
- ETN stands for exchange-traded note. ETNs are mostly bank-issued notes with total return swaps into whatever asset class is desired. This means the bank is responsible for managing the underlying hedge portfolio, and a buyer is exposed to some credit risk (if the bank defaults). However, a swap also means they track their index perfectly (before fees).
There are other ways to structure ETPs, too. Some hold cash and futures or physical commodities, often to track commodities (like: IBIT). These are generally regulated under the 1933 Securities Act, which regulates new security issuance, but not how investments within them are managed.
Today, to keep things simple for the rest of this post, we’ll use the term ETF.
ETFs evolution: More choice and more active portfolios for investors
Early ETFs were exclusively index funds. SPY, the S&P 500 index ETF, was the first to launch in the U.S. It was followed by Select Sector funds like XLE (Energy) and XLK (Technology), which also follow S&P indexes. In the 1990s, there were also tradable country index funds run by banks that later became some of the earliest iShares country funds.
Over time, the SEC closed the gap between classic end-of-day stock selection (active funds) like mutual funds, closed-end funds and ETFs, allowing more active stock selection with easy arbitrage mechanisms. First with ETFs tracking smart beta indexes, then with transparent active ETFs.
Importantly, all of those ETFs allowed investors (and market makers) to see the whole ETF portfolio every day. That made arbitrage much easier.
For funds with heightened concerns of other traders potentially seeing the active fund’s activity and increasing trading cost, the most recent development is approval of active non-transparent (ANT) ETF portfolios. Having less clarity about what stocks an ETF holds does make arbitrage less certain, but based on the spreads of many ANT ETFs, it seems the market worked out a way to keep tight spreads without market makers incurring losses from mispriced quotes.
Chart 3: Evolution of different ETFs, as the SEC closed the gap between index ETFs and active mutual funds
These days many ETFs are not market-cap weighted; some are actively picking stocks, and others mirror the portfolios of established active mutual funds. ETFs let you buy bonds, international stocks and even commodity exposures – all using a stock brokerage account.
Some of the newest ETFs also offer a portfolio of stocks that are an easy way to invest in some popular themes.
What is net asset value?
Net asset value (NAV) is the value of the ETF portfolio per ETF share.
It sounds relatively simple to calculate – you just add up the:
You could think of it as the price you should pay for the ETF, except that’s not always true!
That’s usually because the stocks in the portfolio are not trading at the exact same time as the ETF. In those instances, the portfolio includes some old (or “stale”) prices.
In some cases, the time delay between markets can be large and intraday NAVs are just a guide to the ETF’s current value. For example:
- Chinese stocks in an ETF listed in the U.S.: The Chinese market is closed when the U.S. ETF ticker starts trading, and the U.S. market closes before all the underlying stocks open for the next day. What you will see is that the U.S. ETF will “price in” new news that has happened since the Chinese market closed.
- Bond ETFs: Bond markets publish no public quotes (or “tapes” of live historic trades) for the underlying bond markets, and many bonds don’t even trade every day. That makes it impossible to accurately value the underlying bond portfolio during the current day.
How do ETFs track their portfolio?
Even when those NAV timing differences are large, it can help to look at how the ETFs track their underlying portfolios over longer periods.
The data mostly shows that ETF portfolio managers are very good at replicating their target index. For example, when we look at the performance of the QQQ ETF versus the Nasdaq-100 Index (its benchmark), we see it completely overlaps for a period of more than a decade.
Chart 4: ETFs track target portfolios very well
How much do ETFs trade?
As a group, ETFs trade over $186 billion every day.
That is more than double what the whole European stock market trades each day. Although it’s still not as much as the company stocks in the U.S. market trade, which is closer to $386 billion each day.
The U.S. futures markets trade even more equity exposure, adding to around $670 billion each day. Although we would highlight that futures trading is mostly concentrated in the single S&P 500 exposure.
Importantly, ETFs allow for a much greater variety of hedges than futures. But compared to stocks, they also offer diversification in a single trade.
Chart 5: ETF trading and creations versus stock and futures trading
Some ETFs trade a lot. Often without much impact on the underlying stocks. In fact, the value of creations and redemptions is a fraction of the value of ETF trading, which seems to confirm that often an ETF buyer trades directly with an ETF seller – and stock arbitrage is needed.
Chart 6: Many ETFs trade with spreads much cheaper than the underlying portfolio
That makes sense when you look at the spread of many ETFs – which is a fraction of the spread on the underlying stocks. That makes trading ETFs often cheaper than trading the underlying basket of stocks, as:
- The spreads on ETFs are often smaller and cheaper to cross (Chart 6).
- The bid and offer liquidity on the ETF is usually deeper than for any single stock (Chart 7).
Chart 7: Some ETFs are extremely liquid; others are used more selectively
Some ETFs trade very little (in fact, many are cropped out of the left of Chart 6). However, in our own study, we found that even those thinly traded ETFs often have tight ETF spreads with frequent quote changes. That’s a sign that the market makers are competitively pricing the ETF, ready for any trade to occur. ETF listing exchanges, like Nasdaq, invest a lot in ETF liquidity programs, including using rebates and market tiers, to support market makers in quoting thinly traded products tightly.
Who trades ETFs?
So, who does the most ETF trading?
We know from recent research that retail investors are large ETF buyers, with around 84% of their net buying going into ETFs.
Chart 8: Retail love ETFs; data suggest their net inflow has been about $341 billion since 2019
However, the same research shows that retail contributes to less than 5% of all trading each day in ETFs.
It would seem that mutual funds are not large traders of ETFs either, as ETFs rarely show up in mutual fund 13F holdings.
That most likely means ETFs are heavily traded by hedge funds, banks and market makers. That’s a testament to their low trading costs, providing effective hedging of more customized exposures than futures. It is also supported by the fact that the 100 most liquid ETFs make up 70.5% of all ETF trading, despite being just 3% of all ETFs (larger circles are high and right in Chart 7).
What exposure do ETFs give?
Remember, just because ETFs are U.S.-listed stocks doesn’t mean investors are buying U.S. stock exposures when they trade all ETFs.
Data from FactSet on underlying asset exposures shows that many ETFs have no U.S. stock exposure at all. For example, the chart below shows ETFs provide investors with access to bonds (orange), commodities (Gold) and overseas stocks (dark green).
In fact:
- International stock ETFs add to around $1.45 trillion in assets.
- Bond ETFs add to over $1.6 trillion in assets.
Even ETFs with exposure to U.S. stocks offer different a range of different styles, sizes and sectors of stocks.
Chart 9: ETFs give investors exposure to a variety of asset classes, regions, styles and sectors – in one trade; bond ETFs and overseas stocks each account for over $1.4 trillion of the assets in ETFs
What keeps ETFs tracking NAV: Arbitrage
It’s important for investors that the ETF price tracks its benchmark index. That’s because of three key features:
- Portfolio managers are good at tracking the underlying index, making sure NAV replicates the index returns.
- Arbitrageurs and market makers very efficiently keep ETFs accurately priced and close to a “live market” NAV.
- Creation and redemption make arbitrage cheaper and more efficient.
With futures and options, market makers know that at expiry, their long and short positions will collapse, and profits will be locked in. However, that requires arbitrageurs to hold (sometimes large) positions for weeks or even months. That adds to the financing costs and risks while waiting for expiry, which will be factored into futures prices. It can also result in persistent premiums or discounts.
In contrast, the creation and redemption mechanism allows an arbitrageur to lock in profits and reduce their positions any night they choose.
How ETF arbitrage works
Note that both the ETF and the portfolio have last trade prices as well as bids and offers.
Often, the spread of the ETF will be tighter than the spread of the portfolio (as we show in Chart 10). Then, the ETF is cheaper to trade for a buyer or a seller of the portfolio.
Chart 10: How arbitrageurs look at ETF valuation
Arbitrageurs will need to cross both spreads to lock in each side of their trade and secure their profits instantly. That means:
- Creation arbitrage (ETF is rich): When the ETF bid is higher than all the stocks’ offers — Selling the ETF at the bid + buying all the stocks at their offers = profits.
- Redemption arbitrage (ETF is cheap): When the ETF offer is lower than all the stocks’ bids — Buying the ETF at the offers + Selling all the stocks at their bids = profits (Chart 11 below).
Doing this trading stops the ETF from dislocating further from the portfolio NAV – keeping prices of the ETF and the NAV in-line.
Chart 11: Arbitrage is triggered when both spreads can be crossed profitably
Once the redemption arbitrage trade above is completed, the arbitrager will be long the ETF and short the basket of stocks.
The arbitrageur will have an almost perfect hedge, so market movements won’t change their profits. But there are other costs they may need to pay, from the cost of borrowing shorted stocks to the settlement fees from all the trades.
How does creation and redemption work?
Creations and redemptions make arbitrage even cheaper. They allow arbitrageurs to reduce their long and short positions, reducing the financing and stock borrowing costs we noted above.
How it works is any Authorized Participant (someone approved by the ETF manager) can send their ETF back to the ETF manager and, in return, the ETF manager will send them all the underlying stocks in the basket (or vice-versa) any night, for a small fee.
If we start from the arbitrage trade in Chart 11, we can show how this works ahead of trades being settled (Chart 12):
Chart 12: ETF redemption mechanism (three steps to net out your hedged positions)
The arbitraged position involves a short stock and a long ETF position (Chart 12, Step 1). Because this is perfectly hedged additional market movements won’t affect profits, so there is no market risk.
In a redemption, the arbitrageur gives the long ETF back to the ETF manager, and the ETF manager gives the arbitrageur the underlying shares from the portfolio in return.
The effect of this is shown in the grey box below (Chart 12, Step 2), where effectively the ETF shares are exchanged for real stocks.
That leaves the arbitrageur with long and short stock positions in the same shares that net to zero, requiring no shares to be delivered on settlement (Chart 12, Step 3). This reduces the balance sheet costs of arbitrage to zero and eliminates the need to borrow stock to hold the short position.
However, the arbitrageur does have some additional costs they need to account for that range from almost nothing to thousands of dollars:
- ETF managers charge (usually fixed) costs to do creation and redemption, designed to offset settlement and custody costs of the ETF portfolio.
- Arbitrageurs might also need to pay custodians for settling each line of their trades.
The ETF portfolio does no trading
Redemptions do represent net outflows from the ETF. However, the selling of stocks occurs during the day, by the arbitrageur, as a result of excess ETF selling. Importantly, the ETF portfolio manager sees no cashflows and does no trading.
ETF creation and redemptions are just 5% of their trading
Creation and redemption trades likely happen less than you think. They add to just 4.6% of all ETF trading, and sometimes market-makers will redeem SPY to create VOO if they are doing S&P 500 arbitrage. That’s consistent with the fact that Chart 6 shows that ETFs are often cheaper to buy and sell than the portfolio of stocks themselves.
A number of other studies find that less than 10% of ETF trading likely flows through to underlying company stocks.
In short, it’s unlikely that ETF trading (on its own) impacts stocks returns or volatility much at all.
ETFs are good for investors, and they know it
ETFs allow investors to buy diversified and professionally managed exposures to all sorts of assets. Data shows they track underlying portfolios extremely well, thanks to good portfolio management, efficient arbitrage and the creation-redemption mechanism.
Spreads are also generally cheap — often cheaper than buying a basket of underlying stocks — thanks to an efficient network of market makers.
That makes ETFs a cheap and efficient tool for investors that also minimizes stock-specific risks.
In short, ETFs are good for investors, and they know it.