# Question on ETF theory



## splatapus (Nov 8, 2015)

Short version:
How does the price of the ETF track the performance of the collection of stocks that it holds?


Long version:
Let's take for example XBM.to. It holds shares in 24 mining companies. The ETF is priced at $10.05 right at this moment. If all 24 companys' share values go up by 50% in 5 minutes, then theoretically XBM.to should also go up by 50%. However in order for XBM.to price to move there must be a trade. Judging by average volume it doesn't get traded a lot. So if hypothetically speaking: the underlying assets appreciate in price, but the ETF has not had a trade occur, would there just be a discrepancy left between the two until a trade does occur. Or would the holding company such as BlackRock or Vanguard step in and try to correct for this?


The reason I'm asking is I'm wondering if this is a possible arbitrage situation. I could for example make a web scraper that takes the prices of the companies that the ETF holds, then calculates the expected price of the ETF. Check that against the ETF, and trade on the difference.


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## mordko (Jan 23, 2016)

The short answer is "yes, ETF prices can deviate from NAV, particularly for sparsely traded products".

ETF issuers use professional traders for arbitration to minimize such deviations, although this is not necessary for heavily traded securities.


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## splatapus (Nov 8, 2015)

mordko said:


> The short answer is "yes, ETF prices can deviate from NAV, particularly for sparsely traded products".
> 
> ETF issuers use professional traders for arbitration to minimize such deviations, although this is not necessary for heavily traded securities.


Thanks.

From Investopedia:

"_There may be differences between the market closing price for the ETF and the NAV. Any deviations should be relatively minor, however. This is due to the redemption mechanism used by ETFs. Redemption mechanisms keep an ETF's market value and NAV value reasonably close. The ETF uses an authorized participant (AP) to form creation units. For an ETF tracking the S&P 500, an AP would form a creation unit of shares in all the S&P 500 companies in a weighting equal to that of the underlying index. The AP would then transfer the creation unit to the ETF provider on an equal NAV value basis. In return, the AP would receive a similarly valued block of shares in the ETF. The AP can then sell those shares in the open market. The creation units are usually anywhere from 25,000 to 600,000 shares of the ETF.

The redemption mechanism helps keep the market and NAV values in line. The AP can easily arbitrage any discrepancies between the market value and the NAV during the course of the trading day. The ETF shares' market value naturally fluctuates during the trading day. If the market value gets too high compared to the NAV, the AP can step in and buy the ETF's underlying constituent components while simultaneously selling ETF shares.

In the alternative, the AP can buy the ETF shares and sell the underlying components if the ETF market value gets too far below the NAV. *These opportunities can provide a quick and relatively risk-free profit for the AP while also keeping the values close together. There may be multiple APs for an ETF, ensuring that more than one party can step in to arbitrage away any price discrepancies*._"

I wonder how fast one must act to beat the AP


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## mordko (Jan 23, 2016)

Good luck.


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## TomB19 (Sep 24, 2015)

I've wondered about this, also.

When a short term bond ETF trends down for a long period of time, as has recently been the case with bonds, what happens with the surplus as bonds reach maturity? Who gets that? It ought to be returned to the ETF owners, in the form of distributions, but the yields are very stable.


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## splatapus (Nov 8, 2015)

TomB19 said:


> I've wondered about this, also.
> 
> When a short term bond ETF trends down for a long period of time, as has recently been the case with bonds, what happens with the surplus as bonds reach maturity? Who gets that? It ought to be returned to the ETF owners, in the form of distributions, but the yields are very stable.


By "surplus" do you mean the return of principle used for the initial bond investment? Wouldn't that be used to purchase the next set of bonds rather than be distributed?


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## TomB19 (Sep 24, 2015)

splatapus said:


> By "surplus" do you mean the return of principle used for the initial bond investment? Wouldn't that be used to purchase the next set of bonds rather than be distributed?


Exactly. The assets of the fund will be going up, regardless of share price. The price is disconnected from the value of the assets.

If the fund trends down for a long period of time, should it not then trend higher for a period? What would happen if everyone sold their shares? The fund would have a surplus or shortage. Who would get the surplus? Who would be responsible for the shortage?

It's almost like a bond backed currency.


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## mark0f0 (Oct 1, 2016)

splatapus said:


> Short version:
> How does the price of the ETF track the performance of the collection of stocks that it holds?


The market, buying securities and exchanging them for ETF units with the 'sponsor', or doing the opposite, keeps the price in line. 

If the ETF becomes overvalued relative to the underlying baskets of shares, a market participant will sell (short) the ETF. And buy the shares. The participant will then take his basket of shares to the ETF sponsor, exchanging the shares for ETF units which will be delivered against the short. 

If the ETF becomes undervalued relative to the underlying baskets, a market participant will buy the ETF, and short the shares. Taking the ETF units to the sponsor for redemption into shares, which are then delivered to close out the shorts. 

While "we" can't generally do this at home because our ETF portfolios aren't that large, there is some risk-free profit to be made through this processwhich someone with, say, a $100M portfolio can undertake. It also keeps prices in line. 



> The reason I'm asking is I'm wondering if this is a possible arbitrage situation. I could for example make a web scraper that takes the prices of the companies that the ETF holds, then calculates the expected price of the ETF. Check that against the ETF, and trade on the difference.


You'd want real time data to do this, and you'd need enough heft to access the unit creation/destruction mechanism of the ETF. Last time I looked into it for XIU, the blocks of XIU required were 80,000 units (20,000 units pre-split), or around $1.7M at today's prices.


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## doctrine (Sep 30, 2011)

You don't actually need a trade to occur to realize value. The bids and asks will rise as fast as the underlying stocks that are being held. For example, the bid and ask on XBM could both rise by 10% in minutes with a comparable sized jump in the underlying stocks. There could be zero volume, but the 10% higher bid means you could realize full value at any second that you so desire.


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## james4beach (Nov 15, 2012)

As doctrine says, you must look at the bid and ask. There might be no trades but the bid/ask might be right where it should be.

Yes there have been times when even major ETFs traded far away from NAV. These certainly are arbitrage opportunities, but with liquid major stocks, it's unlikely you'll find such an opportunity.

It's a good exercise to construct a spreadsheet and calculate the NAV for an ETF yourself based on the underlying securities. Then with daily price changes in the underlying securities, you can calculate what the NAV is


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## humble_pie (Jun 7, 2009)

.

XIU is always complicated by heavy institutional option trading, a large part of which could be Blackrock itself. Here are november 2016 options in XIU. 

notice the extraordinarily high open interest in the options clustered around the 18-22.50 strikes. These are the institutional positions, as they prepare for volatility around the US election.

the open interest columns are the columns circled in red. Calls are to the left, puts to the right.

in normal times, one can always see institutions lurking in XIU options, like alligators slumbering just below the surface. Typically institutional open interest will run 2000 to 10,000 contracts, not the mega-positions up to 30,000 & 40,000 contracts that we are seeing here, i assume for the US election.

Q: can we tell, from the institutional call/put positions, what the XIU traders are expecting?
A: never

i once asked a friend who had worked 23 years in the options broker business, whether anyone could ever tell anything from institutional positions in XIU options. He said no. He said institutions maintain offsetting long/short positions in stocks, other options & futures that we cannot know anything about, when we look at XIU calls & puts.
.











.


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## lonewolf :) (Sep 13, 2016)

I read there are more ETFs that trade in the US then there are large cape stocks, Mania in ETFs ?? future generations might think we were crazy investing in ETFs being @ or close to critical mass in the number of ETFs. Or maybe the trend will keep going higher in number of ETFs so there are 10 ETFs for every stock traded.


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## humble_pie (Jun 7, 2009)

.

here are the december 2016 institutional positions in XIU options on the montreal exchange. The post US election open interest in the decembers is higher than ever.

let's look at those 164,805 december puts with a strike price of $21.50. Let's assume that 4,805 of those contracts belong to retail trade, while the remaining 160,000 put contracts represent one or more big institutional positions.

it's a colossal position. It means one or more parties are ready to take up & pay $344 million for 16 million shares of XIU on tuesday 20 december 2016. That's more than a third of a billion dollars. Only institutions the size of blackrock could place orders of this magnitude.

of course, there have to be hedging orders in place, so that the entire third of a billion dollars would not fall into negative margin on december 20th. Still, the table below shows an awesomely serious amount of money tied up in december 21.50 puts, which in turn shows how serious the big financial houses are about the US election.

PS let no one think that because those are puts, they necessarily represent a bearish position. If anything, they suggest a bullish position, ie the main direction of the strategy could be bullish but the principals have bought insurance in the form of puts just in case.

one has to keep in mind that the montreal option market makers or counterparties who took the counter positions in those 164,805 contracts had to go to the exact same TSX top 60 stocks that form XIU itself, in order to hedge their own positions. 

it's like a dance. A gavotte. In with the baskets, on with the options. Out with the baskets, curtsey & bow. Adjust the options. Everything intricately connected. Perhaps the merest hint of incest. 
.


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## TomB19 (Sep 24, 2015)

Mordko answered this question in post #2 but for some reason, I never really got it until I read an article on ETF mechanics a couple of days ago.

http://www.etf.com/etf-education-center/how-do-bond-etfs-work

When the market capitalization goes below NAV, "authorized participants" can buy shares, have the ETF provide the proportion of bonds the shares represent, and the "AP" can then sell the bonds. In other words, when you buy an ETF and the price drops, someone else gets the difference between the NAV and the capitalization. Brilliant! Not for investors, of course, but brilliant for those who get to arbitrage the fund for profit at zero risk.

How many bond ETF holders realize there are parasites pulling value out of the ETF, beyond the management costs?


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## andrewf (Mar 1, 2010)

I don't follow the parasite comment...


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## mordko (Jan 23, 2016)

He is implying that earning money through price arbitration is being "a parasite". There is a trend to denigrade people earning money for the services they provide.


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## TomB19 (Sep 24, 2015)

I would like to provide the service of buying ETF shares, having them transferred in kind to bonds worth more than the shares, and then selling the bonds. When a bond ETF price drops below the asset value, I will provide the service of removing some asset value right into my trading account. It's a service I will happily provide.

Can either of you hook me up? I'd appreciate it. Thanks in advance.


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## andrewf (Mar 1, 2010)

Nothing is stopping you. You do realize that APs do it for tiny spreads, right?


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## TomB19 (Sep 24, 2015)

I understand the spreads are typically small, but they do not have to be and occasionally are not.

The point is, when the market cap is lower than the NAV, Bond ETFs respond by extracting assets. Rightfully, that arbitrage should be distributed but is kept as a "service fee". This is mode of operation is part of the ETF charter.

As for what's stopping me, please explain how I can transfer my shares of XSQ in kind to bonds? I wasn't aware that option was available to me. Thanks in advance.


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## andrewf (Mar 1, 2010)

To get the underlying bonds, you need to get enough units of the ETF to redeem the underlying assets. Drop Blackrock a line and they will tell you how many you need. Often it is about 50,000 - 100,000 units.


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## mordko (Jan 23, 2016)

...in other words about $10M should suffice to get into the game.

Of course you'll be playing against professionals, so you better know what you are doing.

Good luck!


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## andrewf (Mar 1, 2010)

Fighting with pros over nickels and dimes.


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## TomB19 (Sep 24, 2015)

Pros don't waste their time with nickles and dimes.


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## andrewf (Mar 1, 2010)

When the pro is a computer, they pick up nickels and dimes all day.


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## humble_pie (Jun 7, 2009)

nickels & dimes are what pros do. Once the parties settle down into their ruts the work becomes effortless.

thankx tomB for refreshing this thread. It's made me realize more clearly than ever what a key role derivatives play in the life & times of a canadian ETF fundco.

.


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## james4beach (Nov 15, 2012)

TomB19 said:


> When a short term bond ETF trends down for a long period of time, as has recently been the case with bonds, what happens with the surplus *as bonds reach maturity*? Who gets that?


The bonds don't ever reach maturity. Bond funds always roll down the yield curve, selling them as they near maturity and reinvesting in longer maturity bonds. As they do this, the bond fund maintains a constant average maturity and continues to get maximum return from the money.

Example 1

Say that a bond fund contains one bond that matures in 2 years. After one year passes, the bond is now 1 year to maturity. At this point the fund might sell the bond at a low yield to maturity and reinvests that money into a new longer maturity bond at a higher yield to maturity. As a result of this activity:

* the average maturity of the fund was kept constant
* the same money is put to work at a higher rate of return

As long as there is a liquid market to sell the bonds, and a normal upward-sloping yield curve, the fund managers won't ever let the bonds mature because this forfeits potential return you can get.

Example 2

From my own bond portfolio. My portfolio held a 2019 bond with yield-to-maturity of 0.72%. This means that when I look at the value of this bond (I can sell it for $10,850 cash), that money is working at 0.72%.

The portfolio's average maturity was getting too low, and I needed to boost it higher. I sold this bond at 0.72% YTM, took the $10,850, and bought a new bond maturing 2025 with 1.62% yield-to-maturity.

This means that instead of working for me at 0.72%, that same money is now working for me at 1.62%. Along with this came a shift upward in the average maturity.


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## TomB19 (Sep 24, 2015)

I appreciate the additional information in this thread. Thank you.

I've dropped BlackRock a note, requesting information on becoming an authorized participant. I'll post back any response I receive in this regard.


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## andrewf (Mar 1, 2010)

APs are not necessarily in the arbitrage business, they are providing liquidity for a spread. They can't perfectly hedge their exposure. It's often non-trivial to build and or liquidate the creation/redemption units, because they can have hundreds or even thousands of constituent securities.

If you're looking for evil money-grubbing actors in the finance industry, it's not the APs.


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## humble_pie (Jun 7, 2009)

TomB19 said:


> I've dropped BlackRock a note, requesting information on becoming an authorized participant. I'll post back any response I receive in this regard.



tomB surely you'd want to own an inventory of puts before you move to acquire any securities by exchanging baskets with a fundco such as blackRock? that way you'd keep your loop closed.

option strategies are a force multiplier for an ETF fundco as well. Many or possibly most of what they'd be delivering to an AP will be acquired by them by winding up certain derivative positions.

thankx tomB i can see better, now, how the moving in & out of securities by the APs is necessary to keep the fund clean, ie keep it close to the actual index it's supposed to be tracking. Frequent arbitrage by the APs drains excess option premium out of fundco. Especially helpful for draining excess negative premium.


.


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## andrewf (Mar 1, 2010)

HP, the ETF really holds the securities in the creation/redemption units, so that is what they would deliver.


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## humble_pie (Jun 7, 2009)

andrewf said:


> HP, the ETF really holds the securities in the creation/redemption units, so that is what they would deliver.



andrew it's true that you have always been one to voice the official sales story, that ETFs hold all of their securities in outright ownership. Plus somehow the ETF fundcos are paying for expensive professional 3rd party custodial services for these securities - custodial services run at roughly .50% of a stored security's value - even though fundco MERs indicate that there are no custodial expenses.

but meanwhile all the ETF fundco prospectuses recite that they engage in securities lending, representational sampling, swap, futures & option trading & other synthetic portfolio strategies.

once again, may i mention that i have nothing against any of these practices. I am even somewhat knowledgeable about synthetic security positions myself. What i strongly oppose is exactly the kind of misrepresentation set forth in the quoted remark above.

millions of investors are being fooled into thinking that ETFs have in their possession, at every minute night & day, all of the unemcumbered securities which the regulators still permit them to publish as "holdings." The fundcos are not even required to show which of their "held" securities are, in reality, out on loan, or present as samples only, or present only in the form of synthetic derivatives.

should one blame the regulators for failing to properly serve consumers, then? not really, since the regulators are themselves part of the industry. Finance is a self-regulating industry. Until enough consumers demand greater transparency & more clarity, there is no reason for the fundcos to divulge any of the information i'm referring to.

however, the power of the pen is mighty. Right here in this forum, you yourself have seen how efforts to produce clarity in FX fee charging have paid off, with brokers now taking a myriad of steps to favour consumers or at least to inform consumers better when they are being charged outrageous FX fees.

may i mention also that i distinctly recall yourself freely admitting - to haroldCrump & myself - in a discussion of this same issue a couple years ago, that ETFs do lend securities to hedge funds in return for the fees that sustain their true MERs, which in reality are far higher than the laughable .05-.15% they frequently sell to their investors.

might you kindly reflect on this question: how can an ETF fundco redeem securities that it no longer holds, having already loaned out such securities to a hedge fund via an accomplice broker? the only way such ETF fundco can manage creation/redemption as pledged is to hold long synthetic positions for the missing securities, so that they stand ready to deliver on the redemption pledges.

.


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## andrewf (Mar 1, 2010)

I think the same discussion also showed that securities lending represented a small portion of overall assets. I think you exaggerate the risks and level of exposure. When challenged you seem to admit you think there is nothing wrong with these practices in principle, yet the average person reading your comments will likely be quite alarmed at such seemingly fraudulent activity.

It's no different than what happens in brokerage accounts. Do you really own those securities, if your broker lends them out?


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## mordko (Jan 23, 2016)

Generally one making a wild accusation should have something to back it up. 

When Vanguard, Blackrock and others running index ETFs clearly state that their index funds hold securities rather than derivatives, you can't just say "no they don't". And if they say that only a fraction of one percent is on loan at any time, you can't just say "they are lying". You need to show evidence. Well I guess you can say any **** you want, and keep scaremongering to you heart's content, but anyone with more than one braincell should be able to see what it's worth.


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## james4beach (Nov 15, 2012)

> And if they say that only a fraction of one percent is on loan at any time


The amount of securities out on loan can be very significant, so I agree that's a real concern. I pulled the figures from iShares audited financial statements

http://canadianmoneyforum.com/showthread.php/98145-Securities-lending-amounts-in-ETFs

XSB and XIN both have 20% (one fifth!) of the fund assets out on loan. I really think that's dishonest to the investor. You buy these funds expecting to hold certain stocks, and in reality you are only holding 80% of them, with another 20% of your holdings being collateral with the pledge to repay your original securities at market value.

Mind you, the brokerages where you keep "individual stocks" might also be lending those shares out. None of this matters unless the brokerage collapses, but still, I think investors should be aware that the shares that are listed in their brokerage account may not actually exist at the brokerage.


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## mordko (Jan 23, 2016)

We've been through this. There is nothing particularly dishonest in the practice because it's all declared. If you are concerned with the practice - don't buy XSB or XIN. Buy individual securities/bonds. Or buy VTI, which lends very little.


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## TomB19 (Sep 24, 2015)

> Hi Tom,
> 
> We received your email regarding the process of becoming an authorized participant (AP). Would be happy to help in any way possible. As for the process of becoming an AP, it requires an underwriting agreement with us, that you are a participant of CDS and must complete BlackRock RQA testing (typically requires semi-annual financial statements).
> 
> ...


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## TomB19 (Sep 24, 2015)

humble_pie said:


> ... i distinctly recall yourself freely admitting - to haroldCrump & myself - in a discussion of this same issue a couple years ago, that ETFs do lend securities to hedge funds in return for the fees that sustain their true MERs, which in reality are far higher than the laughable .05-.15% they frequently sell to their investors.


There are so many people who deliberately misinform, it becomes difficult to know which few people are trustworthy. In this case, however, it's pretty clear who is truthful and who is not.

When people are hesitant to become involved in "investing", it's easy to understand why. The vast majority of what the average person is told is designed to strip them of their wealth.

Here's what we know.

- When NAV falls below market capitalization, investors take the hit.
- When NAV is above market cap, APs arbitrage the discrepancy.
- It has been said that large institutional investors perform this as a service, perhaps as some sort of philanthropy. I've worked at two financial institutions. I have a pretty good idea of how freely they give away money and are happy to do things for low margins. I'm going to be nice and call these comments a red flag.

Bond ETFs are clearly gamed against the investors. The argument I see here is the parasitic losses are small. Perhaps but these losses have not been quantified. Can anyone quantify these fund losses? It was also presented that APs provide liquidity. I understand there is some value to this.

So... I buy some XSQ. A few fellow XSQ holders become greedy and decide they are moving from bonds to stocks. This will tend to happen in gluts, as the market shifts from a defensive to offensive posture. There are more sellers than buyers so the buyers are APs who exchange their shares for securities and sell at a profit. Myself and the folks who continue to hold XSQ, the "owners", now own pieces of a slightly smaller pie.

How close am I?


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## Spudd (Oct 11, 2011)

TomB19 said:


> - When NAV falls below market capitalization, investors take the hit.
> - When NAV is above market cap, APs arbitrage the discrepancy.


http://www.investopedia.com/articles/investing/032615/how-etf-arbitrage-works.asp


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## humble_pie (Jun 7, 2009)

TomB19 said:


> Myself and the folks who continue to hold XSQ, the "owners", now own pieces of a slightly smaller pie.
> 
> How close am I?



as you know, i'm one who believes that derivatives play a bigger role in the story than the big nobs are required to let on, at least under the present regulations.

so i'm thinking that, following a routine purge of securities as an ETF fundco delivers baskets to its APs, such a fundco will move promptly to replenish its synthetic positions. It will maintain a full complement of covering derivatives at all times. Your pie is likely to fill itself back to normal very quickly.

turning now to the counter-player here, who might be yourself as AP, you would be receiving baskets of overvalued securities at irregular intervals. Should you not be maintaining long put contracts all of the time? so you could dispose of the now-&-then baskets at locked-in profitable prices?

.


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## andrewf (Mar 1, 2010)

TomB19 said:


> There are so many people who deliberately misinform, it becomes difficult to know which few people are trustworthy. In this case, however, it's pretty clear who is truthful and who is not.
> 
> When people are hesitant to become involved in "investing", it's easy to understand why. The vast majority of what the average person is told is designed to strip them of their wealth.
> 
> ...


Not very. APs are making the same 'arbitrage' in reverse.

When price > NAV, there is excess demand for the fund. In order to satisfy that demand, APs gather the constituent parts of the creation unit, and deliver that to the ETF in exchange for a block of units. The fund grows, more units are available to satisfy the demand, bringing the price down, and the NAV per unit is not directly impacted by these transactions. The AP makes a small spread between the price of the units it sells and the cost of the creation unit (NAV) plus transaction costs. 

When price < NAV, there is insufficient demand to hold units of the fund. An AP can then step it to absorb the excess inventory of fund units, and exchange them for the basket of underlying securities. The AP then disposes of these assets. The fund shrinks in size and the NAV per unit is not directly changed as a result of these transactions. APs buying units supports to the price of the fund and brings it closer in line with NAV.

No one claimed that APs are performing this function out of charity. It's more like a utility. They are executing a boring function for the lowest cost possible. There are plenty of competitors that are ready and willing to step in and do it for less, if they can. Some ETFs have less liquid underlying securities and are harder to perform this function for. These are the funds that tend to deviate more from NAV depending on fund flows. Keep in mind that this is not perfect arbitrage, since the AP assumes some risk in the process of creating and redeeming fund units. They do what they can to hedge that risk, but it cannot all be hedged away, and there is a cost to this hedging. And because there can be large bid/ask spreads in the underlying securities or little liquidity, they may have a hard time acquiring/disposing of the underlying assets at the NAV of the underlying fund.

Long story short, there are plenty of villains in finance, but APs are not at the top of that list.


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## mordko (Jan 23, 2016)

If a guy really wants to believe in evil APs... Whatever. 

I've just had to listen to someone who kept blabbering on about evil bankers per se. Turns out he lost an investment property in the 2009 crisis. Apparently the bank should have bailed him out (he had the money to keep paying the mortgage but it was cheaper to walk away). Wouldn't it be cool if every time you borrow to invest all the risk were to stay with the lender at all times?


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## james4beach (Nov 15, 2012)

And APs and arbitrageurs are not always doing this job. There has been more than one time in the last few years where major ETFs traded very far away from their NAV. Theoretically, those presented huge arbitrage opportunities but nobody stepped up to do it.

The example I remember particularly well was bond ETFs during the financial crisis. Even major bond ETFs (LQD and AGG) strayed very far away from NAV and were trading at significant, multiple % discounts to NAV.

Imagine the selling pressure as institutions dumped LQD like crazy, driving the share price lower. The APs probably looked at that and said "I'm not stepping in front of that freight train" (it would involve them buying heavily distressed, illiquid bonds during a crashing market). It's good to remember that arbitrage will not always happen.

Bond ETFs in particular present an arbitrage challenge because corporate bonds are often illiquid. ETFs like LQD and XCB gives the perception that the bonds are highly liquid... you see the ETF price trade with narrow spreads and high volume, and it all feels very liquid. But the underlying can be quite illiquid. This is probably the core reason that the share price strayed so far from NAV and I'm sure it's why APs stepped away.

I'm not a fan of bond ETFs. There are many shortcomings in their structure and implementation... ETFs that contain liquid stocks (like XIU and SPY) are a different matter. This was the traditional purpose of ETFs and I still think they're great for that.


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## TomB19 (Sep 24, 2015)

humble_pie said:


> so i'm thinking that, following a routine purge of securities as an ETF fundco delivers baskets to its APs, such a fundco will move promptly to replenish its synthetic positions. It will maintain a full complement of covering derivatives at all times. Your pie is likely to fill itself back to normal very quickly..


If they are investing in higher risk investments, they must be generating higher yield than the fund seeks to replicate or else what would be the point of the increased risk? If they are generating higher yield than the mission statement prescribes, that money must be syphoned from the asset pool somehow. If this is not the case, why wouldn't they just buy bonds and sell shares in ownership in the pool? You know, the way they present that they do? In other words, what is being accomplished by the complexity?

XSQ objective:



> Seeks income by replicating the performance of the FTSE TMX Canada Liquid Short Term Capped Bond Index™, net of expenses.


I do take note it cites "replicating the performance of..." with no recipe for how this is accomplished.




andrewf said:


> Not very. APs are making the same 'arbitrage' in reverse.


... so they are voluntarily buying bonds and selling them to the ETF at less than what they paid for them? I'm confident that I misunderstand the point you are trying to convey.

However, your point is in contradiction to this quote from the link Spudd provided three posts up. According to the article, shares are created at NAV. This must not be the case, as it would be a loss for the AP. There must either be a fee or an opportunity provided for the AP to make money.



> ETF arbitrage can occur in couple of different ways. The most common is through the creation and redemption mechanism. When an ETF issuer wants to create a new ETF or sell more shares of an existing ETF, he contacts an authorized participant (AP), a large financial institution that is a market maker or specialist. The AP’s job is to buy securities in equivalent proportions to mimic the index the ETF firm is trying to mimic, and give those securities to the ETF firm. In exchange for the underlying securities, the AP receives shares of the ETF. This process is done at the net asset value of the securities not the market value of the ETF so there is no mispricing. The reverse is done during the redemption process.
> 
> Read more: How ETF Arbitrage Works | Investopedia http://www.investopedia.com/articles/investing/032615/how-etf-arbitrage-works.asp#ixzz4RUyHZuyw
> Follow us: Investopedia on Facebook


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## humble_pie (Jun 7, 2009)

TomB19 said:


> If they [ETF fundcos] are investing in higher risk investments, they must be generating higher yield than the fund seeks to replicate or else what would be the point of the increased risk? If they are generating higher yield than the mission statement prescribes, that money must be syphoned from the asset pool somehow. If this is not the case, why wouldn't they just buy bonds and sell shares in ownership in the pool? You know, the way they present that they do? In other words, what is being accomplished by the complexity?
> 
> XSQ objective:
> 
> ...




many fund prospectuses do contain language like the above. *"Seeks income by replicating the performance."* 

a fund facts page or holdings list will declare or strongly suggest that an ETF does "hold" a precise & particular list of securities. But buried within the prospectus - which investors never read - or if they skim a prospectus they don't understand it - buried within the prospectus will be the above kind of semantic ambiguity. Also buried deep within the prospectus will be declarations that the fund engages in representational sampling & derivatives trading in swaps, futures & option contracts.





TomB19 said:


> However, your point [andrewf's point] is in contradiction to this quote from the link Spudd provided three posts up.



agreed. The Wikipedia presentation that Spudd linked to upthread is correct, i believe (thankx Spudd.) I believe andrewf may have gotten his < > symbols reversed . each:


tomB, here's another grist for your mill. I don't know if your bond fund declares annual phantom capital gains in the way that XIU declares them. These are taxable "capital gains" attributed to each XIU shareholder, upon which gains tax is payable in the year of receipt; however the investor does not receive any additional units or any cash.

blackRock offers a gobbledygook explanation of the phantom gains that no one ever understands.

me i'm wondering whether the phantom "gains" are an accounting modality that permits blackRock to adjust its books in order to flatten or neutralize leftover vestiges of its sampling or derivatives trading practices throughout the year ...


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## TomB19 (Sep 24, 2015)

Thanks for that gem. lol!

I've never seen that with any of the ETFs I've held. I've held XIU but only for about six months. If I was still a couch potato, I would undoubtedly hold a bunch of XIU.

Back to the fundcos....

The reason I use short term bond ETFs is they are a safe place to park money while I wait for the market to do something. If these ETFs are loaning the assets, doesn't that suggest these bonds aren't as safe as owning bonds? I imagine these large institutions are extremely stable but surely safety is reduced with the complexity of these products?


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## humble_pie (Jun 7, 2009)

andrewf said:


> When price > NAV, there is excess demand for the fund. In order to satisfy that demand, APs gather the constituent parts of the creation unit, and deliver that to the ETF in exchange for a block of units ...
> 
> When price < NAV, there is insufficient demand to hold units of the fund. An AP can then step it to absorb the excess inventory of fund units, and exchange them for the basket of underlying securities. The AP then disposes of these assets.




sorry but the way i see it, the > < symbols may have been reversed?

when price > NAV, why would any AP deliver higher-priced components of a fund as a creation unit while accepting lower-priced units in exchange, which is what andrewf describes? this does not make sense to me, maybe i'm missing something.

surely what the AP would do is short their own components (higher prices) while buying units of the fund (lower prices) to cover their shorts, imho.

similarly, when price< NAV, an AP's strategy would be the opposite of what andrewf seems to be describing, although andrew's term "step it" is too vague for purposes of this technical discussion.


spudd's wikipedia link upthread does appear to describe the strategies correctly.

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## humble_pie (Jun 7, 2009)

TomB19 said:


> The reason I use short term bond ETFs is they are a safe place to park money while I wait for the market to do something. If these ETFs are loaning the assets, doesn't that suggest these bonds aren't as safe as owning bonds? I imagine these large institutions are extremely stable but surely safety is reduced with the complexity of these products?



my concern is not with the lending itself, nor with the use of representational samples in lieu of the securities which the fundcos somewhat brazenly claim they are holdings in their holdings lists.

nor is my concern with the synthetic positions they maintain via derivative contracts, without disclosing the presence of these swaps, futures or options in their annual financial statements.

my concern is only that knowledge of these positions & activities is far too veiled. The opaqueness may comply with present regulations but this only underscores the fact that the regulations should be updated so as to require greater transparency & fair disclosure for all consumers.

banks, for example, do disclose their extensive use of swaps & derivatives. Most consumers understand that banks are not holding all of the dollars that retail customers deposit with them. Why shouldn't the ETF fund industry disclose in the same manner?

i do believe that ETFs are slightly less safe than holding their individual securities in outright ownership. But problems would only arise in the case of a global financial collapse. A deutsche bank whiteout would not bring down the entire planet, for example, although it might rub out some ETFs using deutche bank index proxies.

but something like the collapse of 2008/09 could destroy the global financial network. 2008/09 came very close. And we are always skirting closer to that armageddon than most investors would like to think about.

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## james4beach (Nov 15, 2012)

I think it's safer to hold bonds individually than in a bond ETF or mutual fund. This is because:

(1) heavy securities lending in bond mutual funds and poor disclosure, (2) inherent difficulty of bond arbitrage, (3) NAV is difficult to verify because bond managers do a lot of rolling over and bond shuffling

So I hold my own bond portfolio. But I don't have the same criticisms of "plain vanilla" stock ETFs like XIU or XIC. They generally have lower securities lending, have better arbitrage, and NAV is easy to verify.


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## andrewf (Mar 1, 2010)

james4beach said:


> And APs and arbitrageurs are not always doing this job. There has been more than one time in the last few years where major ETFs traded very far away from their NAV. Theoretically, those presented huge arbitrage opportunities but nobody stepped up to do it.
> 
> The example I remember particularly well was bond ETFs during the financial crisis. Even major bond ETFs (LQD and AGG) strayed very far away from NAV and were trading at significant, multiple % discounts to NAV.
> 
> ...


The reason APs step back at those times is because liquidity dries up in the underlying securities. If the APs can't transact to hedge their exposure, they're going to be reluctant to play that role. It's also worth calling out the distinction between APs and market makers. I think quite often they are one and the same, but my understanding is that ETF advisors often contract one or more companies to act as a market maker for their funds.


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## andrewf (Mar 1, 2010)

humble_pie said:


> sorry but the way i see it, the > < symbols may have been reversed?
> 
> when price > NAV, why would any AP deliver higher-priced components of a fund as a creation unit while accepting lower-priced units in exchange, which is what andrewf describes? this does not make sense to me, maybe i'm missing something.


When (fund) price > NAV, it means that the constituent pieces of the fund (NAV) are cheaper than equivalent units of the fund (price). NAV is the value of the underlying assets.


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## andrewf (Mar 1, 2010)

TomB19 said:


> If they are investing in higher risk investments, they must be generating higher yield than the fund seeks to replicate or else what would be the point of the increased risk? If they are generating higher yield than the mission statement prescribes, that money must be syphoned from the asset pool somehow. If this is not the case, why wouldn't they just buy bonds and sell shares in ownership in the pool? You know, the way they present that they do? In other words, what is being accomplished by the complexity?
> 
> XSQ objective:
> 
> ...


I guess in clearer terms:

When the ETF is worth more than NAV, the AP makes more ETF units and sells them for a small profit over the cost of the underlying assets. They only do this when price is sufficiently greater than NAV to be worthwhile.

When the ETF is worth less than NAV, the APs buy units and redeem them for the underlying assets, which they sell for a small profit over the cost of the fund units. They only do this when the price is sufficiently lower than NAV to be worthwhile.


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## humble_pie (Jun 7, 2009)

andrewf said:


> When (fund) price > NAV, it means that the constituent pieces of the fund (NAV) are cheaper than equivalent units of the fund (price). NAV is the value of the underlying assets.



OIC, you're using the word "price" to mean fund price as it trades in stock markets?

i was using "price" to mean the actual real prices of the aggregated underlyings. Each AP - they are all supposed to be giant financial institutions - must be running its own pricing model, tracking each component of each ETF they are partnering in.

those NAVs as published by the fundcos would not be reliable. The reason is that in most cases - ETFs with hundreds or thousands of underlying securities - the true value cannot readily be determined. The securities are too illiquid. In the case of bonds the prices depend on an OTC dealer market.

in the case of stocks, with funds holding hundreds/thousands of securities (XIC), often in challenged or corrupt overseas markets (VWO), accurate NAV pricing is difficult or imprecise. The bid/ask spreads are too big, the market for each underlying is too illiquid.

in all these cases, various pricing methodologies abound. Sticking with one methodology or another determines NAV one way, but there will always be different approaches. Should "price" for such an underlying be the bid? should it be the mid-point between bid & ask? should it be the last price (the last price can be days old or severely manipulated, therefore hopelessly out-of-date.)

if i were an AP, i wouldn't pay all that much attention to what an ETF declared its NAV to be. I'd run my own pricing model. I'd be prepared to engage with ETF fundco according to my pricing model, not according to theirs.

so when you said "price" i thought you meant the price for an AP of gathering the constituent components of an ETF for delivery, according to the AP's own model.

as for the difficulties of gathering those components in highly illiquid markets, that is a whole other chapter. It's impossible to swiftly own or buy the constituents of a fund that tracks an index with hundreds or thousands of underlyings. This is another one of the reasons why i believe both ETF fundcos & APs are utilizing derivatives.


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## andrewf (Mar 1, 2010)

For a lot of US ETFs, there is an implied value index (usually the ticker .IV) for the fund that tracks the intraday NAV. But I agree that APs likely would be calculating it themselves to have real-time visibility.


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