Characteristics and mechanisms of ETFs

The ETFs replicate their support according to two distinct strategies. There is physical replication, pure or direct, which consists in reproducing the benchmark index by buying the securities that make it up directly. There is also synthetic or indirect replication, which consists in obtaining the same exposure as the benchmark index by using instruments and derivatives such as performance swaps.

Physical replication consists in holding the securities that make up the reference medium. If the medium is an equity index, then the assembler (manager, management company) will directly buy all or part of the shares of which it is composed. When securities are partially purchased, this is called optimized replication, which reduces costs for indices with a large number of securities; but it can also be problematic if the index is volatile. For example, the CAC40 lyxor ETF replicates the CAC 40 index in its entirety, while the iShares ETF replicates the MSCI World Index in an optimized way by holding 700 of the 1800 stocks comprising the medium. If the index to be replicated is a raw material, then the assembler will store the underlying material. This is the case of ETF SPDR Gold Shares (GLD), which seeks to replicate the performance of gold by storing ingots in London. Assemblers opting for physical replication must use conservators to secure the stored assets. Securities lending is also possible in this case, it generates additional profits and improves the fund’s performance. However, this activity generates a counterparty risk because the securities lent are no longer physically held by the fund, which will receive collateral in exchange. Every day, the management company will publish a list of the securities that make up the fund. This list is called basketball creation. This basket makes it possible to determine the net asset value of the FIC based on the prices of its component securities. When creating new ETF shares, authorized participants (market makers with access to the primary market) may either subscribe for new shares with a cash contribution or with a contribution in kind, by composing a basket of securities identical to the index and subsequently exchanging it for ETF shares. The authorized participants then have the choice between, holding or selling the units on the secondary market, in OTC or regulated markets. For the destruction of shares, the process follows the reverse procedure. This illustration below illustrates how physical replication works.

Source : AMF, ETF : characteristics, inventory and risk analysis, 2016


This mechanism of creation and destruction of shares takes place daily towards the end of the day. Nevertheless, authorized participants have the possibility to disclose their bid-ask range and to carry out transactions at any time during the day because they know the composition of the basket useful for the creation or destruction of shares. This time difference between the publication of the composition of the basket (morning), and the process of creating or destroying shares (end of day) gives these authorized participants an arbitrage role that helps to keep the price of ETFs close to the market value of the underlying securities. This can be explained by the fact that, in the secondary market, the price of ETF shares is determined by matching supply and demand; at some point, if the number of buyers exceeds the number of sellers, then the price of the ETF share increases. When the price rises above the market value of the underlying securities, the shares are considered to be traded with a premium. Thus, at that time, market makers who have access to the primary market (AP) can arbitrate by selling ETF shares at their excessive value, knowing that they will have the possibility at the end of the day to exchange a basket of securities for ETF shares at their market value and thus generate a capital gain. In the opposite situation, in the event of a discount, the process works in the same way. The presence of transaction costs and the level of liquidity of the underlying securities will influence arbitrage and create a price fluctuation band that prevents the ETF price from deviating from its fair value.

The functioning of synthetic replication is characterized by the purchase of one or more total return swaps (TRS), in the form of tenders, from financial institutions. These TRSs allow the management company to track the performance of the benchmark index. Generally, this replication method has a tracking error (or tracking error that measures the risk of ETF deviation from its benchmark) that is smaller than physical replication. Trade on the primary and secondary markets follows the same pattern as for the first method, except that in this situation, purchases of new shares on the primary market can only be made in cash. In Europe, unlike in the United States, synthetic replication is more dominant. This illustration below, allows to represent well the functioning of synthetic replication.

Source : AMF, ETF : characteristics, inventory and risk analysis, 2016




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