As long time visitors to our site will note, we have gradually shifted our focus from mutual funds to Exchange Traded Funds (ETFs) as the latter product has gained very broad acceptance in the marketplace.

I was reminded of just how fast ETFs have gained acceptance after attending a series of meetings and conferences in Hong Kong around the subject of ETFs. As the product is relatively new to the Asian markets, ETF sponsors found it necessary to take a few steps back in their presentations. The concepts that are taken for granted in the relatively mature US and European markets are relatively novel ones in Asia. Going back to first principles can often help clarify one’s thinking.

Exchange Traded Funds

Broadly speaking, ETFs offer almost all of the benefits of traditional open ended mutual funds but add attractive features like lower management fees, trading throughout the day, fairly tight bid offer spreads, good liquidity and no penalties for early withdrawal. Some of these features have been available for decades with closed ended mutual funds (sometimes referred to as Unit Trusts) but the closed ended funds often trade at premiums and discounts to Net Asset Value which are orders of magnitude larger than any potential cost savings or trading benefits to investors.

Fund Management Company vs. Individual Investor

While certainly not the intention, the investor and the fund management company end up on opposite sides of a transaction. In an open ended fund, units are created and redeemed when an investor sends money to the fund management company or redeems his or her units in the fund. While there might be an intermediary, the transaction effectively has only two parties: the fund management company and the investor. Given that most fund management companies have significantly bigger financial muscle than the average mutual fund investor, it should come as no surprise that the fund manager controls the terms of these transactions and is therefore at an advantage.

Unit Trusts suffer from closed structure

In a closed ended fund, units are created once at launch in a process similar to an Initial Public Offering (IPO) for a newly listed company. Like a listed company, a closed ended fund can issue new units in a secondary offering. But once the units are created, they trade on an exchange like any other equity. So again, the transaction has two parties: the fund management company and the investor when the fund is launched and investor vs. an on-market counterparty when the fund is traded on the exchange. As a result, the only time an investor is certain to get a value close to the NAV of the fund is when it when the shares are issued and when the fund is liquidated (or converted to an open ended structure). In between those two events the units can trade at a discount or a premium to the NAV. Since the level and direction of that premium or discount is dependent upon market forces which could be unrelated to the underlying assets, an investor has two elements of uncertainty to contend with when calculating potential returns: returns from the fund’s investment performance and any changes in the discount/premium in the market.

The Third Party makes ETFs work

The difference between mutual funds (open and closed ended) and ETFs is the introduction of third parties to the process of creating and redeeming units in the fund.

The third party consists of one or more institutional investors (often referred to as Authorized Participant or AP) who are able to create and redeem units directly with the fund manager (often referred to as the Sponsor). And behind the APs are the institutional customers and counterparties of the APs who collectively make up 80-90% of the trading in most developed markets.

The third party brings access to a pool of liquidity far greater than the assets in the ETF. As a result, premiums and discounts are quickly arbitraged away as ETFs represent just another tool in the institutional trading toolbox alongside swaps and futures.

How do institutions use ETFs?

Remember that the institutions managing money are not just researching and trading assets. On a day to day basis, fund managers have to contend with cash flows (subscriptions and redemptions), asset allocation changes from Chief Investment Officers, Index rebalancing, tax harvesting, liquidity management, tracking error and client movements (in and out). In short, institutions aren’t just buying an asset because they love it or selling it because they hate it. Most of the trading is actually geared towards balancing the overall portfolio, dealing with inflows and outflows and managing risks.

Why does Institutional participation in ETFs matter?

Institutions dominate trading in almost every asset class. While long term asset prices are decided by the fundamentals, in the short term, institutions call the shots with their overwhelming buying power.

In the case where there are only two parties to a transaction, yourself and an institution, it is fair to say that the player with the greater buying power is very likely to gain the upper hand most of the time. A mutual fund company can stipulate a fee for redemption within 30 days, for example. With a closed ended fund, your sell order has to be matched with a buyer who is more likely than not a professional market participant. Furthermore, the liquidity of a closed ended fund is constrained by the number of units listed. If there are no willing sellers, you might buy at a big premium. If there are no willing buyers, you might end up selling at a steep discount. The net result is “friction” which causes more investment dollars than you might like to disappear in extra fees and wider than expected spreads.

In the case of three parties, the ETF investor is playing alongside two or more institutions each of which have their own agendas and a suite of alternative investment solutions competing for their investment dollars. That competitive tension between the institutions is something that one can “free ride” as an individual investor. Selling an ETF is no longer an administrative event for the fund manager or a trade that needs to be matched by an investor with an alternative view. Trading liquidity arises from institutions arbitraging small differences in asset prices, completing portfolio allocations, changing credit and duration profiles, adjusting beta measures, rebalancing portfolios and a host of other activities. The result? Your trade becomes part of the institutional order flow. Often, that will translate into better pricing for your ETF assets. Better pricing means that more money is left over to boost investment performance.

In the long term investment game maximizing your investment performance so that it can compound to meet your long term investment goals is the only way to play.

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