These days anything even remotely connected with financial engineering arouses suspicion. But all financial engineering need not necessarily end up making a hole in the financial system. Exchange-traded funds or ETFs stand as a good example of successful financial engineering. These follow what is called “in-kind creation and redemption”—an innovative structure that puts them on a better footing than our mutual funds.
Johnny: Generally, we see a dog wagging its tail, but with a little bit of innovative engineering we may actually see a tail wagging a dog.
Jinny: I think that kind of engineering is already visible in our financial market. Look at our ETFs. One ETF is enough to wag a dozen stocks. Isn’t that more exciting?
Johnny: Surely, that’s exciting. But tell me, Jinny, how are exchange-traded funds able to manage that feat?
Jinny: To understand that you need to understand how ETFs are created. Let me give you a basic idea. All ETFs have a master in the form of an asset management company, called a “sponsor”, that makes all the plans for the creation of an ETF. It is the “sponsor” of an ETF who decides the scope of that particular ETF, such as which index or which commodity their ETF would represent, or which stock exchange their ETF would be listed on. In fact, a sponsor needs to put many things together. But sponsors do not work alone. Once the plan is ready, sponsors enter into agreement with “authorized participants”, who are generally large institutional investors.
Johnny: What role do such authorized participants play in the creation of ETFs?
Jinny: You always need two to tango. Sponsors and authorized participants tango together for “in kind” creation and redemption of securities. Under their agreement, authorized participants hand over the shares of actual companies to sponsors; in return, sponsors hand over “creation units” to authorized the participants.
The sponsors hold the shares of actual companies in a trust account. These “creation units” can be exchanged anytime with the shares lying in the trust account and vice versa. One “creation unit” may typically represent a lot size of 50,000 shares or even higher, which means that all transactions of creation and redemption take place at a very high volume. That’s the reason why only institutional investors act as authorized participants. In the entire transaction, no exchange of cash is involved and that’s why we call it “in kind” creation and redemption. By using “in kind” transfer, the parties avoid booking an actual capital gain or loss that would occur in a cash transaction. So the parties have no need to pay any capital gains tax, you see!
Johnny: But other than tax benefits, what’s this tango all about? I mean, what do authorized participants ultimately do with creation units?
Jinny: Authorized participants act as per the plan of sponsors. Creation units are used to create smaller shares which represent fractional interest in the creation units. These shares are listed on the stock exchanges and are ultimately sold to retail investors for cash. Trading in a particular ETF takes place only through the purchase and sale of these listed shares. Creation units and the underlying shares lying in the trust account with sponsors do not come into the picture unless you try to reverse the whole process.
Illustration: Jayachandran / Mint
In that case, the authorized participant would first acquire a sufficient number of the listed shares of a particular ETF, get it converted into at least one creation unit and finally get the creation unit redeemed for the actual shares lying in the trust account. This reverse process is always available but retail investors need not actually use it because they can get out of a particular ETF at any time by directly selling the listed shares to some other investor. But the facility of creation and redemption greatly helps in keeping the price of ETF shares closer to the value of the underlying shares in the trust account.
Johnny: Oh really? Can you elaborate how the price of listed shares remains closer to the value of the underlying shares?
Jinny: Well, that’s possible because authorized participants eagerly wait for such arbitrage opportunities. In case the listed shares of an ETF are selling at a price lower than the actual value of the underlying shares, then it makes sense to acquire a sufficiently large number of listed shares and get them converted into a creation unit that can be exchanged for more valuable underlying shares.
Buying listed shares in the normal course will push up their prices, bringing them closer to the value of the underlying shares.
Conversely, if the listed shares of an ETF are selling at a higher price, then the reverse process would follow—authorized participants would surrender the underlying shares and get the creation unit which can be used to create more valuable listed shares of a particular ETF.
Johnny: This piece of engineering has really aroused my interest, Jinny. I wish I knew which ETFs are actually available for trading on our stock exchanges. I will check out their website first and then ask you in case of any doubt.
What: ETFs follow an “in-kind creation and redemption” structure.
Who: “In-kind creation and redemption” takes place between sponsors of a fund and authorized participants.
Why: “In-kind creation and redemption” is popular because it’s tax efficient and helps in keeping the price of ETF shares aligned with the underlying assets.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org