Choose Your Own Adventure with ETFs
Ask a CIO #19
I’m always a little sad to see the summer go. Then, after a blurry September, our family settles into the school year routine, and I remember just how much I love the fall season. There’s cooler weather, changing leaves, apple cider donuts, and football (fly Eagles fly).
In the investment world, fall also brings conferences and annual meetings. It gets a little hectic, but it’s wonderful to see friends and colleagues in person. These gatherings provide space to exchange ideas and insights, discuss trends, and share the occasional industry gossip. Sometimes there’s even consensus on market expectations (but usually not).
Among the trends that get discussed these days is the rise of retail investors and how managers and the market are adapting. ETFs are one area that has seen enormous investor demand, and it’s been fascinating to watch the resulting growth and innovation in ETF products.
This week, I thought I’d highlight a question that I’ve been receiving in person from various folks.
ETFs are easy for people to understand. Is there a way to put an endowment-style portfolio (with public and private investments) into an ETF?
My direct answer to the question here is – no, I don’t think so – which admittedly is not a particularly interesting answer.1 That said, I definitely appreciate the intent behind the question, and it’s a great launching point to highlight some of the complex and more interesting things that are happening in the world of ETFs.
Before going any further, as a quick reminder, ETF stands for exchange-traded fund. At the end of the day, every ETF is a fund, run by a fund manager. I emphasize this point, because I think it’s easy to think of ETFs as just traded tickers and not spend a lot of time pondering what is underneath that ticker. And in the case of the best known, passive ETFs that track well known indices (e.g., SPY), there’s often no need to think that deeply about it.
But as ETFs have grown increasingly diverse in their offerings, including varied investment themes, actively managed strategies, etc., it becomes more necessary to understand how the fund itself is constructed.2 For instance, with some thematic ETFs, it would be helpful to understand the index methodology and resulting holdings. Otherwise, you run the risk of being generally right on an investment idea, but specifically wrong in how you’re invested (e.g. hypothetically speaking, picking an AI themed ETF that generates negative performance despite the AI backdrop).3
Next, if you’re up for it, let’s go one layer deeper into the mechanics of how the ETF market works.
There are typically two main characters in the formation of any ETF – the fund manager and the authorized participant. The fund manager is pretty self-explanatory. The authorized participant (“AP”) is the character responsible for creating and redeeming ETF shares with the fund manager.4 Together, the fund manager and the AP are considered the primary market participants for any given ETF.
Simplified example of how it works with an S&P 500 ETF:
The AP purchases all the stocks at the appropriate weights for the index and creates the S&P 500 portfolio
The AP delivers the S&P 500 portfolio to the fund manager
The fund manager takes the portfolio of stocks and issues shares to the AP,5
Finally, the AP takes the newly created shares of the S&P 500 ETF and makes them available to the secondary market, where you can purchase or sell shares through your brokerage account.6
That’s how a fund of many varied holdings gets wrapped up into an ETF and sliced into new ETF shares that you as the end investor then can purchase or sell through your brokerage account. Reverse the process to remove/redeem shares out of the system. This mechanism might seem convoluted, but it’s why ETFs trade real time on exchanges, and more importantly, why the price on the ticker that you see closely matches the value of the fund manager’s portfolio (net asset value or NAV).7
The constraints of this mechanism also determine what types of investments can be turned into ETFs. Every piece in the fund manager’s portfolio has to be liquid enough to support the AP’s ability to create new and redeem out shares of the ETF. To bring it back to the original question – these constraints make it effectively impossible to create an ETF out of a portfolio with illiquid underlying holdings. Hence, no endowment-style ETF.
Admittedly, since starting Ivy Invest, I’ve become much more aware of the importance of fund structures or wrappers (and the wide range of wrappers to choose from). I now fully appreciate that the ability to fit investments into certain wrappers can bring meaningful benefits.
It’s sort of like those USPS flat rate delivery boxes. If you can figure out how to fit your items into that box, you can ship it domestically for a fixed rate, regardless of distance or weight.8 From a fund manager standpoint, if you can fit your investments into that ETF flat rate box, you’ll have relatively predictable transactions and a known delivery system/marketplace. (It’s not a perfect analogy, but you get the point.)
There’s ample flexibility within the rules for creating ETFs (underlying holdings could include stocks, bonds, currencies, commodities, options, etc.) and plenty of marketplace benefits to being an ETF. Combine those two factors with the vast creativity of financial market participants and we have the current ETF market.
There are highly levered ETFs on single stocks, crypto-linked ETFs, AI-powered ETFs. Just in the past several weeks, I’ve learned about actively managed ETFs that donate proceeds to nonprofits and ETFs that can deliver the tax benefits of an exchange fund. There are a lot of choices out there! I tend to think that more choices are generally a good thing, but buyer beware.
I’ll finish on an amusing ETF note – the boom in ETFs has reportedly led to a run on catchy ETF tickers, where some issuers are sitting on tickers they may or may not ever use.9
Thanks for joining this week, and as always, reach out at: askacio@ivyinvest.co!
Until next week,
Wendy
ETFs are subject to a 15% illiquid holdings restriction, but that’s not the only reason I would say no.
The NYSE cites over 3,500 U.S. listed ETFs, and the Wall Street Journal recently noted that investments in ETFs have grown in the past decade from $1.5 trillion to more than $10 trillion. While most of these assets are in passive ETFs, about $1.0 trillion is invested in actively managed ETFs.
Or as anyone who has invested in discretionary macro strategies could probably tell you – getting a macro theme right is one thing, but actually expressing that theme through profitable trades is a very different thing (and far more valuable).
Authorized participants are technically registered self-clearing broker dealers, and there are only a handful in the U.S. The ETF can’t exist without at least one authorized participant that agrees to create and redeem shares of that ETF.
There’s a bit more nuance – typically the AP has to deliver a portfolio of stocks that is equal to the value of some minimum number of shares (e.g., 25,000), and the fund manager then gives the AP that set number of shares.
The shares actually go through a market maker, and the market maker fulfills the orders that you and others place through the exchanges.
If the price of ETF shares were worth more than the value of the underlying holdings, the AP (at the direction of a market maker) would buy the underlying portfolio at a discount, deliver the portfolio to the fund manager to create new shares, and receive the shares that are worth more than the portfolio holdings delivered. This arbitrage would then quickly be traded away by the market makers.
Yes, up to 70 pounds. But that’s a pretty great deal!
Source: Bloomberg