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The ETFHandbook

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The Wiley Finance series contains books written specifically for finance andinvestment professionals as well as sophisticated individual investors andtheir financial advisors. Book topics range from portfolio management toe-commerce, risk management, financial engineering, valuation and finan-cial instrument analysis, as well as much more. For a list of available titles,visit our Web site at www.WileyFinance.com.

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The ETFHandbook

How to Value and TradeExchange-Traded Funds

Second Edition

DAVID J. ABNER

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Copyright © 2016 by David J. Abner. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Webat www.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,(201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

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Library of Congress Cataloging-in-Publication Data:

Names: Abner, David J., 1969- author.Title: The ETF handbook : how to value and trade exchange-traded funds /David J. Abner.

Other titles: Wiley finance series.Description: Second edition. | Hoboken, New Jersey : John Wiley & Sons, 2016.| Series: Wiley finance series

Identifiers: LCCN 2016017302 (print) | LCCN 2016020692 (ebook)| ISBN 9781119193906 (cloth) | ISBN 9781119193791 (ePDF)| ISBN 9781119193913 (ePub)

Subjects: LCSH: Exchange traded funds.Classification: LCC HG6043 .A26 2016 (print) | LCC HG6043 (ebook) | DDC332.63/27–dc23

LC record available at https://lccn.loc.gov/2016017302

Cover Design: WileyCover Image: © Lee Yiu Tung/Shutterstock

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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For Mom and Dad

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Contents

Preface ix

Acknowledgments xv

Introduction xvii

PART ONEIntroduction to the ETF Market Place 1

CHAPTER 1How Did We End Up Here? 5

CHAPTER 2Steps for Developing an ETF 32

CHAPTER 3Giving an ETF Life in the Markets 50

PART TWOETF Trading and Execution 69

CHAPTER 4Trading Volumes and ETF Liquidity 71

CHAPTER 5Volume ≠ Liquidity—Understanding ETF Implied Liquidity 96

CHAPTER 6Execution 128

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viii CONTENTS

CHAPTER 7Market Participants and Their Trading Strategies 155

CHAPTER 8Market Structure and ETFs—Protecting Your Portfolio from FlashCrashes 181

PART THREEETF Valuation 207

CHAPTER 9ETFs with Domestic Holdings 209

CHAPTER 10ETFs with International Constituents 224

CHAPTER 11Fixed-Income and Currency ETFs 240

CHAPTER 12Leveraged, Inverse, and Commodity Products 266

CHAPTER 13Structure of an ETF 281

APPENDIX ABloomberg ETF Reference Guide 304

APPENDIX BETF Issuers 314

APPENDIX CAn Overview of Japanese ETF Market 316

APPENDIX DAn Overview of European ETF Market 322

About the Author 327

Index 329

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Preface

The number of available exchange-traded funds (ETFs) and the quantityof assets underlying them has been growing exponentially in recent years.

For the future growth of the industry it is important for new users of theseproducts to understand how to execute trades in the broad range of ETFs.Educating a new and expanding client base has become a universal endeavoramong ETF issuers. Even the largest ETF providers in the industry have prod-ucts that do not trade the high volumes of the few most popular products. Inorder for the client base to utilize the broader range of available products,it needs to understand how efficient executions are achieved. Understand-ing the proper methods of valuing and trading ETFs will enable investors toexpand their product usage. It will enable the trading community to providethe services necessary to nurture the future growth of this young industry.The ETFHandbook presents both the tools necessary for valuing these fundsand the concepts required for trading and executing ETF order flow. Thisinformation is important for traders and for the investor base.

ETFs IN THE REAL WORLD

Recently I encountered two examples that clearly demonstrate the need forthis information. In the first, I received a call from a client seeking help inexecuting ETF order flow. The client’s initial comments were: “I’ve beentrying to buy two of your ETFs and the intraday volume is very light. I havebeen bidding for the shares for about a week, and I haven’t been getting anyexecutions. Can you help me?” This was not the first time I had heard thisrequest. The adoption of the ETF product by an expanding user base hascreated a flood of such client calls to product issuers. I have been dealingwith similar inquiries for the past 15 years. In the early years, the questionsinvolved helping the new product adopters, primarily institutions and hedgefunds, to achieve desired liquidity.

Lately, I have found myself in the role of champion of the smallerinvestor, helping advisors and our broader client base to achieve theirdesired executions in a more complete suite of ETFs. First, I attemptto understand what the clients have been doing so far and what theirinvestment goals are. In this case, the client was an advisor trying to buy

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x PREFACE

50,000 shares each of two of our ETFs that each trade approximately15,000 shares daily. The typical market that would be quoted on the ETFsis roughly 10 cents wide with approximately 500 shares on either side ofthe market. Without a solid understanding of how the ETF market works,one might think this would be a multiday trading adventure or, worse,a hopeless situation. It is far from that, however, and I was able to helpthe client achieve a very satisfactory execution. I learned that the clientwas placing very small limit orders on the bid side of the market. Then,every time the market started moving down, he would lower his orderprice. By doing this, he never let liquidity providers see any real size tobuy in the ETFs; and he never let his order get near the value of the ETF,where opposing liquidity would be provided. This is the same as settingout in a boat to go fishing but never actually dropping a line in the waterwith a hook and some bait. You may be out fishing, but you will not catchany fish!

The client and I then had a conversation about his investment goals.I explained to him how the valuation of an ETF is determined. I explainedthat, in a low-volume ETF, most of the trading will take place against aliquidity provider. It is important to let the provider know you are willingto trade at a price close to the ETF value for the provider to be willing tooffer the desired liquidity. With that understanding in mind, we calculatedthat the fair value for each of the ETFs was approximately three cents insidethe offer side of the market at the time. So we did something that seemedvery radical to the client: We decided to show our whole hand electronically.Instead of bidding for just 500 shares at a time, the client put a bid in eachETF into the system for all 50,000 shares at the price he was willing to paythat was in line with the valuation of the ETF.

The ETF marketplace has grown so broad that you sometimes need totrigger the alerts on trading systems in order to trade. This is analogousto a bell being attached to the door of a store so the proprietor can hearclients coming in and out. When the large bid showed up in ETFs that didnot trade very much daily volume, the liquidity providers were alerted viatheir systems. Sometimes, if I see a large bid or offer show up in one ofmy products, I will call the liquidity providers myself to make sure theyare aware of this trading opportunity. We did not adjust our price basedon small market movements, interpreting them as noise within our strategy.This client’s intention was to place a longer-term trade with a significantupside goal. He was indifferent as to whether he paid $30.10 or $30.07, buthe had been adjusting his pricing as the market moved around. This kepthim constantly under the fair value level that would enable his order to besatisfied. The upshot of this situation was that both of his large orders werefilled almost immediately.

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Preface xi

His executions make sense for several reasons. For one, he was biddinga level in the ETF that was considered to be fair value by the liquidity-providing community. He also showed enough size to attract some attention.The client was very satisfied with the executions. He had achieved the expo-sure hewas looking for in the ETFs at a price that hewas comfortable paying.He had not initially understood where the liquidity came from but was nowcomfortable with amethod that he could use to get in and out of his positionsin an acceptable manner. There are many intricate details to learn to achieveexecutions in your ETF orders. What is even more important to understand,however, are the concepts of what is happening in the marketplace. You willfind all of those details in this ETF Handbook.

The second example shows the client achieving exposure via analternative solution. This time, I received a call from a very large institutionindicating that it liked the methodology behind our ETFs and wanted tomake some purchases. It had heard about the potential liquidity availablein ETFs and wanted to learn more about the ways of executing orders toachieve institutional goals. The caller was concerned because the ETFs theywere interested in were trading with very low average daily volume. Sincethis was a large institution, it wanted to buy several hundred thousandshares of several ETFs that tended to trade fewer than 50,000 shares per day.Its investment horizon was longer term, and it was indifferent as to whetherit traded today, the following day, or even over a few days if required.

This type of order flow utilizes one of the most important facets ofthe ETF structure: the creation and redemption mechanism. This client hada trading relationship with a large broker-dealer who happened to be anauthorized participant (AP). Being an AP enables the broker-dealer to inter-act directly with the ETF issuer in the creation of new ETF shares. To achievethe desired execution, the client gave the AP the order to buy the ETFs ata price based on the net asset value (NAV). The AP went into the markets,purchased the shares underlying the ETF, and delivered them to the issuer.In turn, the issuer delivered new ETF shares to the AP, who then deliveredthem to the client. The client was able to achieve an execution in line withthe net asset value of the funds without having an impact on the ETF pricein the marketplace. In this scenario, the average daily volume of the ETF wasirrelevant because the client never actually traded the shares in the secondarymarket. Executions of very large size can be accommodated in the ETF struc-ture utilizing this method; this ability has helped to facilitate their growth.Executions of smaller size, however, can also be executed this way by access-ing the liquidity aggregators and understanding how that business works.The details of creations and redemptions and utilizing liquidity providersare found throughout this handbook because they are critical functions ofthe entire ETF structure.

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xii PREFACE

WHAT YOU WILL FIND IN THIS BOOK

This book has three main parts that will appeal to different sections of theETF universe. Part One introduces the various structures of exchange-tradedproducts, the methodologies underlying those products, and the ways ofbringing them to the marketplace. Part One is written from the perspec-tive of my role within an ETF issuer. I have been working at an issuer foralmost ten years at the time of the writing of this book. I had been tradingETFs for more than ten years prior to deciding to move to the other side ofthe fence. A brief history of my interaction with the ETF product may behelpful to you.

Throughout the mid-to-late 1990s, I was running the closed-end fundbusiness at Bear Stearns in midtown Manhattan. I was facilitating customerorder flow and running a proprietary trading strategy pursuing discountarbitrage opportunities. I was also a frequent user of the Country Websproducts available at the time. Those products later became the basis forthe iShares single-country ETF product set. One day a salesman on the deskstood up and said to me, “I’ve got an order in a strange fund I’ve neverheard of, can you make a market?” Since that was my role at the time,I agreed. I was not well versed in the product but made a market in theQQQs (Nasdaq 100 Index Tracker) to satisfy the client’s request. Almostimmediately I lost a very large amount of money in my trading portfolio.In researching what went wrong, I learned much more about the productand became enthusiastic about this newer investment vehicle. It was thenthat I began to realize the potential of this unique product for the tradingcommunity and started to build an ETF business at Bear Stearns. I neverexpected the volume and asset explosion we have experienced in the lastfew years.

At that time I had my entire career leveraged to the markets and to mytrading performance. I had always been a basket or fund trader and wasnever very comfortable buying single-company stocks. To manage my per-sonal portfolio, I invested in mutual funds, mostly plain vanilla ones. I wasdiligently dollar cost averaging a small amount every month and watchingit grow. When I got married in 2000 and my wife and I proceeded to buy ahouse, I sold all of my mutual fund positions to provide a significant downpayment on the property. Two years later, when I had more money to investand the ETF trading business began to soar, I decided I would never buy amutual fund again but would utilize only ETFs for investing. I realized thatthis product makes great sense for the investor. I wanted to be involved inhelping bring ETFs to market and helping investors utilize them for theirinvesting goals. That is what planted the seed for my move to a seat at ayoung and innovative ETF issuer several years later.

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Preface xiii

Part One of this book presents many of the concepts related to bringingETFs to market and how they fit into the investing landscape. I have avoidedpresenting more than a brief history of the ETF or reviewing every detail ofthe product mechanics, since those topics are well covered by other books.I focus on topics and concepts that have not been previously discussed indetail and may not have been fully understood unless the reader worked fora product issuer or had been a liquidity provider in the products. I bringthe insider’s perspective to the investor with the hope of creating a broaderunderstanding for all interested parties.

We are living through a revolution in theway people invest. Never beforehave so many different investment products been available to investors atthe click of a mouse via an electronic brokerage account. A leveling of theinvesting landscape is taking place that is bringing the tools of the institu-tional universe to the masses. As with any material shift in mindset or newproduct adoption, there are learning curves involved. The techniques forexecuting order flow in this investment vehicle are still not widely knownand understood. Yet they are crucial because a main feature of the productis its availability on an exchange like an ordinary stock.

Part Two goes into an unappreciated core of the ETF ecosystem: trading.It is amazing how little some investors, large and small, know about thetrading mechanism underlying the product that might make up their entireportfolio. I go deeper than ever before into the trading mechanism of theproducts, their underlying liquidity, and providing new ways for investorsto rank products for usage within their portfolios by a detailed presentationof implied liquidity and my EBILS ranking system for ETFs. I also introduceyou to all the different types of players in the ETF ecosystem.

In Part Three I discuss the mechanics of calculating the fair value forthe products. I explain why an international ETF might be trading awayfrom its intraday indicative value (IIV) during the trading day. Part Threealso details the types of products available in the commodities category andthe varying structures of the currency ETFs. Part Three presents a frame-work for understanding how to value those products to build the foundationfor effectively executing ETF order flow. I often speak with people whoare interested in getting into the ETF business; this will help them under-stand how the valuation process works. When an exchange-traded productmoves to a premium, for instance, if you understand its underlying mecha-nism, you will know why this may have occurred and what may happen inthe future.

Incredible growth and change is occurring in the universe of exchange-traded products every day. At the end of the book, I provide appendicesthat will lead you to some information about the industry. There is a guideto using Bloomberg for ETFs. I provide a list of issuers and their web page

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xiv PREFACE

addresses. There are some details on global ETF markets in Japan andEurope to touch upon what is happening in the industry beyond the bordersof the United States.

TRADING TIP

Throughout the book you will see highlighted sections to bringattention to specific points regarding trading ETFs in the market.

AS YOU BEGIN

This book is not the first book on ETFs. I bring to the reader, however,an insider’s view of what is behind the curtain. The book is unique bothin its content and in its perspective. It will help as a guide to the properutilization of ETFs. The investing public deserves to know and understandthe details of how the products work. The trading community needs to buildan infrastructure capable of handling the avalanche of ETF order flow tocome. It is my hope that readers will take advantage of the features of ETFsand use them for many years of profitable investing and trading.

DISCLAIMER

The concepts and ideas in this book are my own. I am in no way representingWisdomTree Asset Management with anything represented in this book.There are risks involved with investing, including possible loss of princi-pal. In addition to the normal risks of investing, foreign investing involvescurrency, political, and economic risk. Funds focusing on a single country orsector and/or funds that emphasize investments in smaller companies mayexperience greater price volatility. Investors should consider the investmentobjectives, risks, charges, and expenses of the fund(s) carefully before invest-ing. Please seek the counsel of your accountant for any tax-related matters,as no tax guidance is presented in this book.

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Acknowledgments

Ihad no idea of the difficulty that lay ahead of me when I agreed to updateThe ETF Handbook for a second edition. In a way, writing books is sim-ilar to having babies. Having watched my wife go through childbirth threetimes, I am amazed that anyone would willingly choose to do it even once,let alone multiple times. But when you look at the child you have created,those difficult hours are almost completely erased from your brain. I am notimplying that writing books is as difficult as having babies, but when yousee that book in print, the agony of the work is forgotten! So when I decidedto rewrite for the second edition, I could scarcely remember the hard workof the first. There was still demand for the information provided, and I feltduty-bound to provide the necessary updates.

I learned three things from this updating process:

1. Much of the core ETF mechanics information provided in the firstedition is still relevant today and will be throughout the lifespan of theproduct set.

2. The ETF industry has more than doubled in five years and thus there isa tremendous influx of new industry participants for whom this infor-mation is very important.

3. The people who were happy to contribute to the first edition generallymade themselves scarce if they noticed me looking for assistance withthe current work!

Only two people helped me with both editions of the handbook. AnitaRausch has been a friend of mine for longer than I care to recall. She isalso a tremendous asset to the WisdomTree team as she guides the effortsof our Capital Markets group. She has read every word of both editions,which are immeasurably better because of her contributions. Our daily con-versations about the industry have greatly influenced my thinking. And mymother-in-law, Lynne Cohen, has read every word of both ETF handbooksand even the Visual Guide to ETFs and rearranged my words into actualsentences that make sense. Anyone who makes it through this text shouldthank her personally for enhancing their reading experience. Alissa Klein-man assisted by bringing those changes into the digital world.

In the beginning of this endeavor I took on the assistance of an intern.BenjaminHershkowitz, a student at Yeshiva University, was the driving force

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xvi ACKNOWLEDGMENTS

behind much of the organization of the information in Part One. In the shorttime we had together, he displayed the passion that a “millennial” can havefor the ETF industry.

Since my books focus on the mechanics and trading of ETFs, it makessense that the Capital Markets people in my office are always offeringtheir opinions. Zach Hascoe, Michael Barrer, and Paige Corbin were ready,willing, and able to help. Not only do they bring a wealth of knowledge,they also exhibit positive energy unrivalled among competitors. I was ableto tap the next generation of Fixed Income ETF information in Ambar Bajaj.He reviewed and improved the fixed income chapter. Rebecca Sheehan isalso deep in the thick of the ETF industry. She helped with a variety ofcomponents of the book and I can’t thank her enough for that assistance.Ryan Louvar applied his structural mastery to the section explainingthose facets of the industry. That chapter is much tighter thanks to hiswork. The appendix on Europe was assembled by Rafi Aviav and NathanJiang. The appendix on Japan was assembled by Masafumi Watanabe.

The team at WisdomTree is amazing. Hungry for ETF information thatcan be distributed to investors, they push every day to explain the mechan-ics better, to help investors gain a better understanding, and to innovatebeyond compare in the financial products arena. Every day I am honored tobe working alongside this team.

I am always amazed at how many friendships I have developed inthe industry. One friend in particular, Julie Abbett, is passionate about thisindustry and brought her vast experience to bear on reviewing pieces of thebook. I can’t thank her enough for the help she provided.

I didn’t imagine when I agreed to write the second edition how dramati-cally my life would change during the process. I became deeply involved withour firm’s global expansion that caused me to travel more than I expected.My wife and children are so supportive it’s sometimes unbelievable that theyare not furious with me! But they’re not. They want me to finish up andspend more time with them, but they also seem genuinely proud and con-sider themselves fellow soldiers in the ETF revolution. Lin-Manuel Mirandasummed it up perfectly for them in the words of Hamilton, “This is not amoment, it’s the movement”! And they are not throwing away their shot!

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Introduction

Exchange-traded funds (ETFs) are the most interesting products in thefinancial industry today. In the same way that Lego building blocks are

used by both children and adults to make creations of all sizes, ETFs arethe portfolio building blocks of the modern age, usable by investors of allsizes and for a variety of portfolio demands. Small investors are enthralledwith the lower fees, ease of use, and exchange listing standardization ofETFs, while large institutions can benefit from innovative products andadvanced portfolio management tools, coupled with lower fees and greatertransparency.

The most frequently cited chart in the ETF industry is shown inExhibit I.1, demonstrating ETF asset growth over time.

This is one important way to look at ETFs. Assets under managementshow the amount of dollars committed by investors to the strategies, enablingindustry observers to understand the top-line revenues of the industry par-ticipants. Another way to look at ETFs is via industry trading volumes overtime. You can see the evolution of trading volumes in ETFs in Exhibit I.2.

From the percentage of volume trading in the markets on a daily basis,you can observe how important ETF products have become to the entireecosystem of market participants and the markets in general.

Over the years, I have answered many questions about ETFs. I havespoken at conferences, I have had thousands of individual meetings withinvestors of all sizes, and I have written two books explaining these products.Youare holding the second editionof the first book Iwrote about this industryin 2010.Afterwritingmyfirst book, I realized that there are twomain types ofinvestors interested in ETFs: One type of investor wants to ask in-depth ques-tions, read articles and books, and have meetings. The other type of investorwould rather read something brief that explains just the salient points. Inthis second edition, I will help both types of investors. I hope this makes TheETF Handbook, Second Edition more accessible for all types of readers andinvestors, no matter how deep they want to dive into the subject.

To begin, I will first lay out some important and frequently asked ques-tions about the industry, providing answers to each. The following questionsand answers will give you a strong foundation for understanding the industryand will be useful as a reference tool as you navigate your way through usingthe products.

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xviii INTRODUCTION

71 88 106 157 237 314433

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95 118 130 134 169221

381

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1099

13701445

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1661

1836

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200

400

600

800

1000

1200

1400

1600

1800

2000

0

500

1000

1500

2000

2500

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

# U

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AuM and # US ETPs

AuM # US ETPs

EXHIBIT I.1 Asset Growth ChartSource: BlackRock, Bloomberg

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

ETFs as a Percentage of Value and Shares Traded in US Markets

Percentage of $ Value

Percentage of Share Volume

EXHIBIT I.2 Trading Volume GrowthSource: Credit Suisse Trading Strategy Group

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Introduction xix

QUESTIONS ASKED ABOUT ETFs

1. What are the main differences between an ETF and a mutual fund?An ETF can be considered to be part of the mutual fund product set.Both products are pooled investment trusts launched under the Invest-ment Company Act of 1940. The markets have changed dramaticallysince the 1940s and there are pieces of the 1940 Act that are not asimperative in a more modern age.

The main features of an ETF that are different from a mutualfund are:i. Exchange listing—This leads to standardized product use across

the investor spectrum, the ability to trade throughout the day, andenhanced liquidity as compared to traditional mutual funds.

ii. Daily transparency of holdings—This enables all investors to under-stand the fund holdings every day. This facilitates the arbitragefunctionality ensuring that the ETF and the underlying assets cantrade in a manner that is independent yet related.

iii. Tax advantages—Many ETFs pay out much lower capital gainsdistributions than a corresponding mutual fund. This is due to thenature of the creation and redemption mechanism enabling the ETFto transfer assets into and out of the fund without generating taxconsequences across all investors.

iv. Lower fees—This is a feature of ETFs that is often debated becausewe are in a period of dramatic fee compression across all funds.Whatis not debatable is that removing the execution process from thefund management process leads to lower expenses to investors beingpassed through the mechanism. Investors are not disadvantaged bythe actions of other investors in the same ETF. This is critical becausewhether you are the only holder of an ETF, or one of millions, youare not impacted by the actions of other investors entering and exit-ing the funds. This is very different from a mutual fund that passesthose fees of executing asset changes across the investor base.

Two key differences are that an ETF has to be listed on an exchangeand an ETF takes in assets and disburses assets through a process knownas creation and redemption. Trading on an exchange enables the ETF toact independently from the actual basket of underlying assets while stillbeing tethered to that basket by the creation and redemptionmechanism.This tethering structure is often referred to as arbitrage whereby youcan exchange the underlying basket of assets for the ETF shares and viceversa. This keeps the price of the ETF shares to be trading always in rela-tion to the assets for which they can be exchanged. In a sense, the ETFshares act as a transference mechanism delivering both the performance

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xx INTRODUCTION

and the liquidity of the underlying assets to the holder of the ETF in aconvenient wrapper. If the underlying assets were the only form of liq-uidity for an ETF, then the liquidity would be the same as an ordinarymutual fund. Instead, exchange listing adds another entire component tothe liquidity infrastructure. Because an ETF is listed on an exchange andtrades throughout the trading day, it enables a wide variety of marketparticipants to apply the principles of modern markets to the products.In order to be listed on the exchange the ETF is very transparent, mak-ing its holdings available on a daily basis, and in the U.S. markets ETFshave only a single share class, causing all investors to come together inthe same product on the exchange. This is a big difference from manymutual funds that have multiple share classes for different investors typ-ically at different prices depending on their status. The confluence of avariety of different investors all trading the same product on exchangefor different reasons creates an additional layer of liquidity for ETFs thatgoes beyond the underlying assets. This is liquidity from the marketplacethat develops in the form of participants using the ETFs for a wide vari-ety of trading strategies, and being able to develop highly sophisticatedmechanisms for trading the ETFs against other products. This has ledto a marketplace where ETF liquidity is greater than the liquidity thatmight become available in a similar mutual fund. This is explained inmore depth in the next question.

2. How is the liquidity of an ETF different from the liquidity of amutual fund?At the base level, an ETF and a mutual fund (MF) present the sameamount of minimum liquidity. Investors in a MF can send almost anysize check to the manager, and they will receive shares in the fund. Inthis case the money is going directly to the manager, and the managersare interacting with the brokerage community to purchase the necessaryassets representative of the increase in assets of the MF. In the case ofan ETF, instead of delivering a check to the manager, you are typicallypurchasing your shares directly through a broker in the secondary mar-ket. It is their job to purchase the underlying assets and deliver thoseto the ETF manager, in the form of a “creation unit.” If you are aninstitutional-sized investor, your broker can utilize the creation mecha-nism on your behalf to help you enter your ETF position at net assetvalue (NAV) plus expenses. While the terminology may be different, theconcepts are similar: New money flowing into both structures gets allo-cated to the underlying assets, and new shares are issued. ETF investorsuse a measure called “implied liquidity” to assess how much money canbe invested into a given ETF on a daily basis. This measure is used to tryto prevent market impact from investments. A similar measure is used by

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Introduction xxi

the trading teams at mutual funds to determine how to trade when theyare tasked with purchasing the assets for new investments; that measureis called transaction cost analysis (TCA). So, the first step in thinkingabout liquidity in ETFs versus mutual funds is that if they are based onthe same underlying assets, their base liquidity will be the same.

The ETF, however, has an advantage in liquidity terms because ofthe unitary fee structure, single share class, and daily transparency of itsbasket. Because an ETF trades on an exchange and its holdings are pub-lished daily, a wider variety of potential users can be utilizing the fundon any given day. These additional users can be creating excess liquidityin the ETF that works to the benefit of all other investors in the ETF.The most pure example of this is the SPDR S&P 500 ETF Trust (SPY). Ifyou look at the implied liquidity of the underlying basket, it displays thepotential to trade 35 million shares per day in ETF terms, while being nomore than 25 percent of the average daily volume (ADV) in any of theunderlying stocks. This is equivalent to a potential notional of approx-imately 7.35 billion USD daily. The average daily volume of that fundis approximately 105 million shares per day, or a notional of 22 billiondaily. This excess liquidity that you see in the ETF develops because ofthe variety of other trading strategies for which people use the ETF:things like index arbitrage against the futures, options trades, high-frequency trading strategies, and others. So the ETF presents anadditional amount of liquidity that a mutual fund never can becauseof the wider variety of market participants all interacting in the samestructure, and at the same pricing, on the exchange. We can see thisadditional liquidity in many ETFs, especially those in internationalmarkets. Many ETFs actually trade more in the U.S. markets thanwould be expected if you were only trading the underlying basket.This is the case for those ETFs tracking countries like India and Japan.Interestingly, several of the Europe-focused ETFs could trade manymore potential shares on a daily basis if you examine their impliedliquidity as compared to their average daily volume.

3. Can institutional investors seed ETFs?Any investor can seed an ETF. To “seed” an ETF is really just to makethe first investment into the fund. That typically takes place in the size ofone creation unit (approximately 2.5 million USD) or greater. The pro-cess by which an ETF receives assets into the portfolio is known as the“creation process.” This is when a counterparty, known as an autho-rized participant (AP), delivers the underlying basket of assets to theETF issuer in the proper weights, after which new shares of the ETF areissued to begin trading on the exchange. In the United States, seedersdo not typically receive any benefit versus other investors in the ETF.

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The main benefit is that when you deliver the first tranche of assets tothe fund, you receive the exact initial NAV of the fund. While this is thesame for all creations, it is very clear when it is being done for the firsttime. Often when institutions work with ETF issuers to design prod-ucts around particular investment specifications, those institutions arethe initial investors (seeders) of the fund. This process is great for thegrowth of the ETF because it immediately shows other investors thatthe underlying investment theme has been designed around a currenttarget. While it is not necessary for the institutional investor to haveother investors in the ETF, that growth provides a sense that they arenot alone in their investment thesis. Another benefit of working withETF issuers to develop and seed ETFs is the potential marketing andpublic relations opportunities around the ETF launch.

4. How do I know if an ETF is going to close?Every year many ETFs close for a variety of reasons. Typically, the ETFsclose because of a lack of progress in gaining assets, coupled with achange in strategy from the ETF issuer. Many smaller ETF issuers havelimited resources for running the business; therefore, the expenses ofkeeping ETFs without assets in the markets become too much to bear.The larger ETF issuers generally keep ETFs with smaller amounts ofassets in the markets for longer time periods, as long as they still believethe investment mandate underlying the fund will become valuable toinvestors at some point in the future. ETFs are usually closed because ofbusiness restructurings around the corporate entity, or a desire to takethe product suite in different directions. I have never seen an ETF closethat had significant assets (over $50Million USD) or that had an anchorinvestor for whom the ETF position was an integral part of their portfo-lio. In the scenario where there is a large institutional anchor investor inan ETF, it would most likely be a part of the distribution teams’ respon-sibilities to communicate with that investor when appropriate if the ETFthey held was going to undergo changes or delisting.

5. What happens if my ETF closes?The closing processes of an ETF and a mutual fund are extremelysimilar. If an ETF is going to close, it will announce to all shareholdersin advance: typically, within a window of a stated number of days.Investors then have the ability to sell their shares, utilizing either thesecondary market or the primary market (if they are trading in largeblocks). If you choose to hold your ETF position until it stops tradingon the exchange, at that point the ETF’s underlying assets will besold in the market. The value of those assets will be distributed toall remaining investors. In the case of investors remaining in the fundupon its closure, the costs of selling the remaining fund assets will be

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distributed among all the investors in the fund, which is different thanyou bearing only the costs of your own execution when you make salesin the ETF independently.

6. Is there a risk to being the largest investor in an ETF?Often investors are concerned about being the largest or only investorin an ETF. This is a misplaced concern. The structure of an ETF enablesinvestors to control the execution of their position outside of the actualfund structure. If you were the only investor in an ETF, it would functionthe same way a separately managed account would function, and itsasset valuation and base liquidity would present similarly as if the ETFwas widely held. An important point to keep in mind is that movementsby investors do not impact the positions of other investors in the fund.It is completely viable to be the only holder of an ETF, and you willmaintain all of the ability to enter into and out of the fund without anyadditional fees or restrictions.

Typically, an ETF is launched with a small amount of seed capital.This initial investment is usually provided by the market-making com-munity, which is then using that initial position to provide base initialliquidity in the ETF to facilitate the first trading in the ETF. Seed moneycomes into an ETF in exactly the same fashion as all other creations.ETF creations happen in block amounts of typically 50,000 shares.Redemptions happen in the samemanner. If you are an institutional-sizedinvestor and you have a 100,000-share position in an ETF, you can liaisewith your standard broker and have them redeem your ETF positionevery day. Or you can choose to sell it on the secondary market. SinceETFs are traded on an exchange, the initial shares of an ETF typicallybecomewidely held among investors; thus, even an ETFwith small assetscan have many holders. If you were to accumulate all the shares in theETF by purchasing them on the secondary market, however, you couldcontinue to hold your position. The ETF valuation would be unaffected.And if you chose not to sell any shares, but other buyers came intothe market to purchase, the ETF liquidity-providing community wouldfacilitate that order flow by shorting shares to the new buyers, and thenprocessing creations to flatten their portfolios. The ETF could grow andyou would be able to maintain your position with no changes. In addi-tion, you can be a small percentage of an ETF, but for some reason otherinvestors may choose to sell their shares. If they sell enough shares, theETF liquidity providers will redeem shares, and at some point you canend up as the only holder with 100 percent of the ETF. This also wouldhave no impact on the valuation of the underlying assets or the func-tioning of your ETF position. So there is no additional risk to being theonly investor, or even the largest investor, in an ETF.

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xxiv INTRODUCTION

7. Why is an ETF more tax efficient than a mutual fund?When investors position in an ETF, they bear the costs of execution,both when they enter into the position and when they exit the position.When an investor positions in a mutual fund, the costs of that executionare spread among all fund holders. Let’s walk through the process ofinvesting in a mutual fund and an ETF:i. You place an order and send money to the mutual fund manager.

Their traders then need to go into the markets and purchase theunderlying assets. The costs of purchasing those assets impactthe entire fund, not just your execution, because you are executingat NAV. The NAV of the fund will reflect the cost of bringingthose new positions into the fund. When it is time to unwind yourposition, the trading team at the fund manager will sell a slice ofassets from the fund portfolio, and they will return your investmentproceeds. Because the trading was done within the fund, any impactto the portfolio will have to be distributed among all investors inthe fund. So even if you had no activity within your own position,you are impacted by the activities of other investors in the fund.Also, the NAV is subject to the expenses related to other investorscoming into and out of the fund.

ii. This process is very different for an ETF. When you purchasean ETF, you are typically buying shares via a secondary markettrade, which leads to a creation. That creation involves the brokerpurchasing the basket of underlying assets and delivering themto the ETF issuer. The same happens in reverse when you sellshares: The ETF issuer delivers out a slice of the underlying assetsof the fund. The ETF issuer is not trading the assets in the markets,so any gains that would have been generated from a purchase andsale are not occurring in the fund. This leads to generally lowerdistributions of capital gains in equity index–based ETFs, typicallynone. Additionally, any activity by investors is happening in theshares on the secondary market, outside the fund, and only thoseinvestors are bearing the costs of those transactions. Executioncosts for investors’ moves do not flow into the NAV and impact allinvestors. The actions of other fund investors do not impact yourposition like they would in a mutual fund.

8. Does the number of authorized participants in an ETF aid in the liquidityof the fund?The authorized participants (APs) are typically large ETF market-making businesses at the investment banks and trading firms. Forpractical purposes, they all sign up to be APs in all ETFs, so theydo not have to turn order flow away. There are specialized trading

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firms that only trade certain funds, and in turn they do not sign upat every issuer; this is what drives a slightly proprietary nature tothe AP list. Approximately 90 percent of the APs are the same at allissuers, except for the few specialized firms. This leads to an importantpoint about ETF liquidity and APs: People often assume that the ETFliquidity provider is the AP, and vice versa. This is not the case. Theact of processing creations and redemptions in ETFs is done by APs.To provide liquidity in ETFs, you simply need to be able to trade theproducts on exchange. There are many cases in which an ETF tradingfirm provides liquidity in ETFs throughout the day, and then has theircreations and redemptions processed by their custodian. The custodianis the AP and undertakes stock delivery and receipt responsibilities. Thesame thing is also possible in reverse. That same custodian might nothave an ETF liquidity business in which they trade the ETFs providingmarkets to the street or their customer base. An example of this is anETF trading firm based in Singapore with offices around the world.They trade a large percentage of the ADV of U.S. ETFs, and they useone of their U.S. custodians to process their creations and redemptions.They pay a small transaction fee for the service, which outweighs beingan AP. The act of creation and redemption is merely an operationalprocedure of delivering and receiving ETFs and baskets.

This is important because people often make the mistake of thinkingthat the number of APs equates to an amount of liquidity available inthe products of that issuer. This is incorrect. There is an entire ecosystemof ETF liquidity providers that are trading ETFs, making markets, andproviding liquidity. Indeed, the number of ETF traders is many timeshigher than the number of ETF APs. The capital markets teams are con-stantly cultivating relationships with firms that trade ETFs and ensuringthat they are well prepared to provide liquidity in their products. Thishelps products to trade better, with tighter spreads and more liquidity.

9. Does the amount of assets in an ETF affect the investor experience?Often in the ETF industry you hear of investors who want to investin a particular ETF but are waiting until the ETF reaches a certainasset threshold. Even many wealth management platforms use assetminimums as criteria before allowing ETFs onto the platform. Theserestrictions are based on a misunderstanding of the ETF structure. Onesignificant misconception is the fear that if you try to execute a largetrade in an ETF with small assets, you will impact the price. This issimply incorrect. ETF prices are dictated by the value of the underlyingassets and broad market events at the time. Take a domestic equity ETF:If you wanted to execute $100 million worth of a U.S. large-cap ETFthat only had $10 million in assets, the ETF liquidity ecosystem would

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xxvi INTRODUCTION

work to transfer the liquidity of the underlying assets from the stocksinto the ETF to facilitate that transaction. This happens seamlesslyevery day in thousands of ETFs. Another misconception is that being alarge percentage of the fund holdings restricts your ability to enter andexit the fund. This is also incorrect. All investors are able to go to thesecondary market to enter and exit ETF positions. On the back end ofthat procedure, ETF liquidity providers will utilize the primary marketto grow and shrink the assets, similar to the way just-in-time inventorymanagement works. As a shareholder in an ETF—a product launchedunder the Investment Company Act of 1940—whether you hold80 percent or 1 percent of an ETF you enjoy the same protections of allfund shareholders. Your percentage of holdings makes no difference inyour ability to freely enter and exit the fund, without impacting price,on a daily basis. As the product set has grown we have seen manysophisticated institutions working with ETF issuers to help launch fundsbased on bespoke strategies. Frequently these product launches areaccompanied by significant investments into the ETF by the institution.They have gained an understanding of the structure and have no fearsabout being the only holder of an ETF in large size. This is a sign of theeducation that has taken place in the industry over the last decade.

10. What are the best trading practices for ETFs?When trading ETFs there are some best practices to keep in mind. Firstand foremost is that you should understand what the ETF price is tellingyou about the marketplace. An ETF price is like a window into the viewsof the entire market. It represents what the market thinks is the currentvalue of the underlying assets in the fund. In an ETF with underlyingequity assets that are trading at the same time as the ETF, the price isusually tracking right along with the basket value. For investors payingclose attention to market structure, you may notice whether that ETFprice is trading on the bid side of the underlying assets or on the offerside. This provides a slight indication of market pressures at the momentof trading. In an ETFwith underlying equity assets frommarkets that areclosed while the ETF is trading, the price of the fund represents the con-solidated views of where market participants believe those assets willbe valued when they next begin trading. For example, in a fund withJapanese equities that is trading below the most recent value of its under-lying assets, the fund price tells investors that the market is expectingthose stocks to open lower when they next begin to trade. The fund pricerepresents what the market believes to be the fair value of those assetsat the given time. The fixed-income arena has become a very importantplace for fund investors to gain insight into what has historically beena very opaque market. ETFs that hold fixed income assets tend to be

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real-time pricing mechanisms for bonds that may trade infrequently andwith unclear pricing. The ETF industry has created a real-time pricingmechanism for bonds. Understanding what the price is telling you aboutthe market is the first step in executing ETFs efficiently.

Learning how to deal on an exchange with the various order typesand other market participants is the next set of important concepts tounderstand when executing in ETFs. When you invest using ETFs, youhave the benefit of independently controlling your execution through-out the trading day, in exchange for the complicating factor of having tonegotiate in the open market to acquire or sell shares. An entire ecosys-tem of ETF market participants who facilitate ETF executions has thusemerged. There are those that provide ETF liquidity on exchange forinvestors to interact with electronically, and there are those that workon an institutional basis in a form of off-exchange trading, which is thenprinted to the exchange tape. In recent years, we have also seen the devel-opment of request-for-quote systems, which people can use to interactwith other ETF users to trade shares away from the exchange. Thereare also a wide variety of order types that investors can use to executeall types of orders via the electronic systems. “The Ten Keys to TradingETFs” discussed later in this book will help guide you with all your ETFtrade execution questions.

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