“Mommy, Where Do ETFs Come From?”

It’s the question every parent dreads: “Where do exchange traded funds come from?" If you haven’t heard it yet, you eventually will.

You can just tell the little ones “Ask Ron Rowland," and let me answer the question. Or, after reading today’s column, you might be ready to tackle the question yourself.

ETFs do not come out of thin air. Nor are they delivered by storks. Today I’ll let you in on the secret.

Before we reveal their origin, we must first define what ETFs are. They aren’t mutual funds, nor are they closed-end funds. They are something entirely different that did not exist in the U.S. until 1993.

ETFs are not delivered this way.

The first ETF was based on the S&P 500 and is still around today, under the symbol SPY. And you can read my 2009 column to learn why ETFs have become the hottest business on Wall Street.

The “secret sauce" that makes ETFs different from stocks, mutual funds, and closed-end funds is the creation and redemption mechanism. This is how new shares enter the world and eventually leave it.

Technical? Yes, but it makes a huge difference in your bottom line. So you need to understand it.

The first thing that happens is that a sponsoring firm — a company like iShares, SPDR, or PowerShares, to name some of the largest — files a registration form with the Securities & Exchange Commission in Washington. The SEC has jurisdiction over the stock markets.

Once the SEC grants registration, are we ready to trade? No, not yet. The ETF is now legitimate but has no public shares. They must be created.

This presents a problem. At this point the ETF is nothing but an empty shell. There are no stocks inside. So why would anyone buy it?

Enter the Authorized Participant (AP)

The AP is typically a financial institution that has a special agreement with the ETF sponsor. The AP assembles a portfolio of stocks that match whatever the sponsor says should be in the ETF. It then gives the portfolio — which may be worth millions of dollars — to the ETF trustee. In return, the AP receives shares of the ETF.

Notice that no cash changed hands in this “share creation" transaction. The AP traded shares of stock for shares of an ETF. The value of the underlying assets is the same. All that’s changed is the wrapper. This is important for tax reasons.

The AP takes the new ETF shares it just received and sells them to other investors via regular transactions on a stock exchange. At this point, these newly created ETF shares are freely traded on the open market.

The entire process works in reverse, too. If the AP has enough shares (typically 50,000) of an ETF, it can make a “redemption" and receive the actual stocks in exchange for the ETF shares.

This creation/redemption process keeps the ETF market price from getting too far above or below the ETF’s actual net asset value (NAV). The NAV is the total value of all the securities in its portfolio, less any liabilities, divided by the number of fund shares outstanding.

If the ETF’s price falls too far below the NAV, the AP will buy ETF shares and exchange them for the actual higher priced stocks. When the ETF is trading higher than its NAV, the opposite occurs. These are often called arbitrage transactions, and they are all part of what makes ETFs unique.

Now you might ask …

How Does Anyone Make Money
from All this Activity?

The same way you do when trading anything else: You sell it for more than you paid.

We can know how much an ETF share is worth by looking at its NAV, which is calculated every 15 seconds during the day. But why would anyone pay more than the NAV? That would be dumb, right?

ETF net asset values are published every 15 seconds.

Not necessarily …

Small investors like ETFs because they offer a diversified portfolio in bite-size portions. For example, you probably can’t buy all 500 stocks of the S&P 500 unless you are very wealthy. But you can buy a few shares of the SPY ETF and get almost the same thing.

I say “almost" because most likely you will have to pay slightly more than the actual NAV when you buy shares of any ETF. You’ll also receive a little less than the NAV when you sell your shares. That’s how the market makers earn their living.

The difference in the buying price and selling price at any given time is called the bid/ask spread and is usually related to how specialized the ETF is. Those covering narrow sectors or illiquid foreign markets have a wider spread. Because they have to compete with each other, though, the difference tends to be very small in ETFs. Add in the convenience factor and it is a good deal for everyone.

Now that you understand the process, why does it matter?

It matters because the creation/redemption mechanism is what makes an ETF liquid and cost-effective. Without it, ETFs would be very much like those old closed-end funds that routinely trade 10 percent above or below their NAV — and sometimes even more.

We got a real-world demonstration of this just in the last few weeks …

The Egyptian stock market closed on January 27 when violence broke out, and stayed closed until last week. And as I wrote on February 3, this meant big trouble for Market Vectors Egypt (EGPT).

Source: Bloomberg

With the underlying market inaccessible for so long, no one had any idea what EGPT shares were really worth. And, without the ability to buy and sell the underlying stocks, the creation/redemption process was not able to function properly.

The result was predictable: Dramatically higher price premiums.

At one point, shares of EGPT were trading at a 24 percent premium largely due to the fact that new shares could not be created. It was essentially trading as a closed-end fund. However, EGPT snapped right back in line when the Egyptian market reopened on March 23 after being closed for nearly two months.

Now you know where ETFs come from. Not so difficult, was it? Once you see how creation/redemption works, it actually seems quite simple.

Why didn’t anyone think of it sooner? I don’t know, but I’m glad they finally did. For small investors, ETFs are one of the best inventions ever!

Best wishes,

Ron