2.2 Creating and redeeming ETF 29
2.2.3.2 Creation and redemption arbitrage
The APs that contract with an ETF are a closed group. They are the only people to have the exclusive right to create and redeem shares with a fund company. There are enough APs assigned to each ETF to ensure a competitive market, as well as the tight spreads between the market price and the NAV. They can make money when ETFs are trading at either a premium or a discount.
If ETF shares are selling at a premium to their intraday value, an AP will buy the securities that make up the fund, add cash according to the PCF, and exchange that basket for a creation unit. The AP will then sell the creation unit for a market price greater than the value of the securities turned in. That generates a risk-free profit. The arbitrage trade is repeated again and again until there is no profit left for the AP. At that point the ETF market price and its NAV are probably in an acceptable range.
If ETF shares are trading at a discount to their intraday value, an AP will sell securities that make up a fund and buy ETF shares on the market. Once the APs buy enough ETF shares to form a creation unit, or trade from their account, they will exchange that unit for its underlying cash and securities. The unit redemption covers the
AP for the stocks they already sold. The price arbitrage generates a small risk- free profit to the AP, and the trades are repeated over and over until the profit incentive is gone.
This provision for arbitrage is what fundamentally differentiates ETFs from closed-end mutual funds. A closed-end mutual fund is much like an ETF—it sells shares representing a basket of securities on a stock exchange, and trades just like a stock, but because it has no legal provision for exchanging the shares of the fund for the securities after the fund is created, the share price of the fund frequently deviates by a large amount from the NAV of the fund.
2.3 International experience
2.3.1 In America
a) Overview
The American Stock Exchange (Amex) was the first stock exchange to put ETF into trading in 1993. Currently the ETF with the largest trading volume are ETF NASDAQ 100 Trust Series 1 (QQQQ); S&P’s MidCap 400 Index (MDY); iShares Russell 2000 Index (IWM); and iShares MSCI Japan Index (EWJ).
In America, ETF is a very popular investment tool. The total trading value of ETF is even higher than the trading value of stocks. The average trading value in a day of the 5 biggest ETF fund was 11 billion USD in 2008, tantamount to 3 times the daily
average trading value of the most crossed tickers. ETF Trading Center of America is NYSE Arca. 706 of all 797 ETF listed on American market are traded on NYSE Arca.
ETF funds in America replicate more than 260 indices of many types of assets in different industries, including stocks, money, and goods.
Until now, ETFs in American market have blossomed rapidly; with many new ETFs keep appearing on the market. Besides traditional ETFs, which replicate closely the movements of indices, there are another two special types of ETF in the American market: leverage ETF and inverse ETF. The purpose of these types of ETF is to replicate the movement of the indices proportionately or inverse proportionately (such as 2x, 3x in terms of leverage ETF; or negative 1x, negative 2x in terms of inverse ETF). At the present time, there are about 100 different leverage ETF and inverse ETF replicating goods trading, currency, and stock indices. In America, all ETFs whether inverse or leverage aim for the same target which is to replicate the daily movement of indices proportionately/inverse proportionately. This job requires the fund management firms to monitor and adjust the constituents of the portfolio on a daily basis. There has not been any ETF that replicate the indices movement on a basis more than 1 day.
b) Details
The creation and redemption of ETF are done by either cash mechanism or in- kind distribution. In those markets that are highly liquid, in-kind distribution is preferred because it helps investors to evade tax and save expenses. For those markets that are less liquid such as goods or currency, the mechanism would be done on a cash basis. The creation unit of ETF, which is issued or redeemed, will be traded at NAV, thus APs will benefit from the difference between NAV and market value. The role of APs is to keep the price of ETF close to NAV of the fund, balancing the supply and demand of ETF.
The creation of ETFs is carried out as follows: Authorized Participants decide on the necessary constituents of a stock basket to form a creation unit. National Securities Clearing Corporation (NSCC) will declare the information regarding this basket publicly.
APs will accumulate enough basic stocks or equivalent cash to trade with the fund management firms. The fund management firm will give APs a creation unit of ETF (normally 50,000 shares of ETF). The redemption of ETF is carried out inversely.
Based on the experience derived from the American market, the creation and redemption of ETF only perform well the role of adjusting the supply and demand of ETF in those highly liquid markets. If ETF tries to replicate a market or part of a market that is illiquid, or scarcely traded, the creation or redemption will be less effective. This theory was tested during the economic crisis in 2008. When the American credit market was frozen, ETF iShares iBoxx High Yield Bond (ticker: HYG) on NYSE Arca was traded at a premium of 10% higher than NAV. However, due to the financial crisis, APs were unable to carry out their role of creating and redeeming ETF. Consequently, ETF HYG has been traded at premium ever since.
On the secondary market, ETF is traded using the following orders:
- Market order: buy or sell ETF at the market price
- Limited order: buy or sell ETF at a limited selling or buying price
- Stop price: buy or sell ETF at the market price when ETF has been traded at the price ordered by customers
- Limit-stop price order: combination between limit and stop price
- Short sell order: the transaction whereby the seller sell a security which he doesn’t own
For fund management firms, ETFs generate less profit because of the in-kind distribution process. With ETF, the investors have more tax advantages than traditional funds. Using other types of funds, the fund management firms trade the funds’ assets regularly. Thus, whenever these firms sell the assets and collect the profit, this profit will be taxed. Due to the high frequency of the fund assets trading, the accumulated tax can be gigantic. On the contrary, for ETF, the management firms will not be levied tax when they sell the funds’ assets. The tax on the profit will only be expensed when the whole ETF is sold. For investors, the individual profit will be taxed as regular income. In case
the investor holds the ETF for more than 1 year, the profit will be considered long term and levied at the rate of 15%.
2.3.2 In Taiwan
a) Overview
ETFs began trading on Taiwan Stock Exchange (TWSE) in June 2003. Currently there are 15 kinds of ETFs traded on TWSE, including 11 domestic ETFs and 3 foreign ETFs. By the end of 2010, the total trading volume on the market reached 199,576,486 thousands yuan, in which Taiwan Top 50 Tracker fund accounted for 72% the total trading value.
In Pacific Asia (excluding Japan), by the end of February 2011, the total value of assets under management of Taiwan ETFs is 2.8 billion USD, equivalent to about 5% of total value of asset under management of regional ETFs (54 billion USD). Especially, asset under management of Polaris fund management firm is worth 2.6 billion USD, standing at the 7th position in terms of regional asset under management value, also Polaris Taiwan Top 50 Tracker fund attained the 9th spot in the region with 1,799 billion USD.
Table 5 Development of ETF in terms of trading value and trading value on the Taiwan Stock Exchange
Year Trading value (1000 yuan) Trading volume (1000 units)
2003 779,721 34,119,438
2004 1,690,384 79,306,569
2005 1,670,385 79,438,639
2006 1,533,449 75,211,735
2007 2,440,392 125,371,874
2008 5,905,137 232,039,461
2009 5,979,934 197,837,265
2010 5,527,373 199,576,486
Source: Bloomberg b) Details
According to Taiwan Security Law, ETFs are considered a tool of Securities Investment Trust Enterprise (SITE), bearing the same regulation with the SITE under control of Financial Supervisory Commission. Beneficial Certificates include ETF shares and Real Estate Investment Trust (REITs). Trading of Beneficial Certificates and issuance mechanism, redemption of ETFs are stipulated by TWSE Law.
Creation and redemption of ETFs law specify clearly:
Creation and redemption of ETFs can be done on a cash basis or in-kind distribution.
In case the asset under management of ETFs cover OTC stocks, PDs need to open a respective transaction account for OTC stocks. In this case, after PDs register in- kind distribution ETFs redemption with TWSE, TWSE will transfer the information to GreTai Security Exchange.
Regulations for PDs in creation and redemption of ETFs that have foreign stocks:
PDs are not allowed to exercise stock deposits with the domestic stocks that investors transfer to the fund.
Rule-of-thumb for PDs: after receiving the customers’ orders regarding the creation or redemption of ETFs, PDs can collect the difference in price or other expenses based on SITE calculation beforehand. After determining the real amount that needs to be
paid, PDs will inform the customers of the news to request for additional payment or reimburse the surcharge.
PDs are required to do their jobs through an independent account at their own payment banks.
Issuance and buying back are done in the same way as ETFs including domestic stocks with appropriate adjustments for foreign constituents.
For in-kind distribution of ETFs covering only domestic stocks:
After TWSE receive registration of issuance, including the information of Portfolio Composition File (PCF) published by SITE, TWSE will review and transfer back to SITE for further consideration. Review results will be announced on TWSE system for PDs to look up. PDs will inform the customers of the registration results to confirm and store results and registration information as the base for later review.
Whether SITE approve of the registration or not, it has to inform TWSE of its final decision so that this information is provided to PDs.
PDs will be responsible for sending the detailed information about approved stock portfolio to Taiwan Security Central Depository to exercise deposit. After receiving announcement from TSCD about the deposit results, TWSE will send information to SITE along with uploading to TWSE system for PDs to look up.
If the registration satisfies the specified requirements and approved by institutions, depository institutions will carry out the payment done on cash basis, deposits or relevant expenses on the next business day. The depository institution is obliged to complete transferring ETF shares (or stocks) issued (redeemed) no later than 2 business days after registration.
About short selling: TWSE do not allow for short-selling ETF shares.
Tax, expenses: for all types of ETFs:
o Tax: 0.1% transaction value
o Expense: lower than or equal to 0.1425% transaction value
2.3.3 Lesson learnt
After considering the ETF markets in some countries in the world, some
experience lessons can be concluded for the Vietnam market:
The essential factor that determines the success of introducing an ETF product is to choose the appropriate investment portfolio. The portfolio needs to be attractive enough to get the attention from the investors and implemented in time.
Looking at the other countries, ETFs that replicate index is the prime choice when the country begins to introduce ETF to the market because this is the ETF that is simplest, easiest to understand, helping the investors to have a simple approach to the new product.
ETFs based on real estate, commodity, currency... are usually introduced when the market has evolved to a specified level.
To those countries that introduce ETF for the first time, it is vital to hold propaganda, training session for the market participants, especially supply the investors with the information regarding the benefits and regulations associated with trading ETF.
Almost all countries need to spend years to attract the investors to get acquainted and join in ETF trading.
In terms of legislation, not one country applies the whole set of rules designed for open-end funds or closed-end funds for regulating ETFs. All countries have specific provisions for ETF, many countries even adopt an independent set of rules specifically designed for ETF.
Continuous link between primary market and secondary market is needed to guarantee the liquidity of the market. Secondary trading of ETF could be exercised through listed stock system of Stock Exchanges. For primary market, in many countries, the Security Deposit Center needs to organize a system for receiving orders from agencies of fund management firms and connect with the secondary trading system at Stock Exchange to warrant the continuous flow between these two markets. In other countries such as Taiwan, Stock Exchanges organize both the primary trading and secondary trading system simultaneously, secondary trading as well as primary trading will be carried out through the system administered by the Stock Exchange, having results consolidated and transferred to the Security Deposit Center at the end of the day.
The quantity of ETF shares equivalent to one creation unit is determined
based on the market condition, requirement of fund management firms and other participants to make sure it is not too big for the investors to buy/sell fund shares easily and not too small for the investors to buy/sell too regularly and cause turbulence to the fund share market and structured security.
Arbitrage mechanism is vital in helping to balance the price of ETF and the price of structured portfolio. International countries often apply special provisions to allow for short selling ETF shares and structured stocks to make sure that AP can implement the arbitrage mechanism flexibly as soon as there is a big gap between ETF value and NAV.
Chapter 3: Status of Vietnam stock market and conditions for applying ETF products
3.1 Status of Vietnam stock market