How are ETF shares generated?

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ChinchillaWhiplash
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How are ETF shares generated?

Post by ChinchillaWhiplash »

Was wondering how ETF shares are put out on the market. I would guess in the beginning the fund is created with x $s to start with x amount of shares released. Sort of like an IPO. How do they determine when to create more shares and buy more assets for the fund? Supply and demand would dictate, but they must follow some type of SEC rules or something.
Silk McCue
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Re: How are ETF shares generated?

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ChinchillaWhiplash
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Re: How are ETF shares generated?

Post by ChinchillaWhiplash »

Good info on how ETFs are constructed. Still did not see when new shares/investments are created/added.
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arcticpineapplecorp.
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Re: How are ETF shares generated?

Post by arcticpineapplecorp. »

ChinchillaWhiplash wrote: Sun Sep 19, 2021 2:30 pm Good info on how ETFs are constructed. Still did not see when new shares/investments are created/added.
I think it would be the same process as at the beginning:
The authorized participant borrows stock shares, often from a pension fund, places those shares in a trust, and uses them to form ETF creation units. These are bundles of stock varying from 10,000 to 600,000 shares, but 50,000 shares are what is commonly designated as one creation unit of a given ETF.

Then, the trust provides shares of the ETF, which are legal claims on the shares held in the trust (the ETFs represent tiny slivers of the creation units), to the authorized participant. Because this transaction is an in-kind trade—that is, securities are traded for securities—there are no tax implications.
So if more ETF shares were needed, wouldn't they borrow more shares from a pension fund, place those shares in the trust and use them to form MORE ETF creation units to sell as ETF shares?
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ChinchillaWhiplash
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Re: How are ETF shares generated?

Post by ChinchillaWhiplash »

arcticpineapplecorp. wrote: Sun Sep 19, 2021 2:33 pm
ChinchillaWhiplash wrote: Sun Sep 19, 2021 2:30 pm Good info on how ETFs are constructed. Still did not see when new shares/investments are created/added.
I think it would be the same process as at the beginning:
The authorized participant borrows stock shares, often from a pension fund, places those shares in a trust, and uses them to form ETF creation units. These are bundles of stock varying from 10,000 to 600,000 shares, but 50,000 shares are what is commonly designated as one creation unit of a given ETF.

Then, the trust provides shares of the ETF, which are legal claims on the shares held in the trust (the ETFs represent tiny slivers of the creation units), to the authorized participant. Because this transaction is an in-kind trade—that is, securities are traded for securities—there are no tax implications.
So if more ETF shares were needed, wouldn't they borrow more shares from a pension fund, place those shares in the trust and use them to form MORE ETF creation units to sell as ETF shares?
I would guess so. That would make the most sense. Just trying to figure out how an ETF grows. There are some that have very small AUM and very low volume. Would think some of these smaller funds do not issue a ton of shares to start. Not sure how much it takes to make them grow with new creation units and what triggers this if there are a set number of shares on the open market. Not a ton of info about it on the inter web
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Re: How are ETF shares generated?

Post by MotoTrojan »

They are started with seed capital to create a certain number of shares to help, but coordination with the lead market participant is key to maintain good trading/liquidity initially as new shares are created from inflows. I have seen some instances of low-volume products reducing the creation/redemption unit size after release to help reduce spreads as well.

If you want to learn more or ask specific questions I would get in touch with Wes Gray of Alpha Architect as they provide white-label ETF services and can discuss a lot of the nuances.

Here is his Twitter handle if you use Twitter:

https://twitter.com/alphaarchitect

Recent pod with Wes & Patrick from AA discussing ETF business with Meb may also be interesting:

https://mebfaber.com/2021/09/03/e347-radio-show/
senex
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Re: How are ETF shares generated?

Post by senex »

The investopedia article is misleading (which is common for that site).

To create shares, an AP acquires enough shares to make a creation basket, and tenders them to the fund company in exchange for newly-minted ETF shares. They need not be borrowed (and rarely are). They can be bought in the open market.

To destroy shares (called "redeem" in the industry), an AP delivers ETF shares to the fund company (which it destroys) in exchange for the basket of underlying securities.

If you work this out with pencil and paper (say, create your own ETF that owns 1 share of AAPl and 1 share of TSLA per share of the etf), you can understand the mechanics. And further, you can see that it is profitable to the APs to push the ETF's trading price toward nav, which is quite elegant.
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Lee_WSP
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Re: How are ETF shares generated?

Post by Lee_WSP »

senex wrote: Mon Sep 20, 2021 3:59 pm The investopedia article is misleading (which is common for that site).

To create shares, an AP acquires enough shares to make a creation basket, and tenders them to the fund company in exchange for newly-minted ETF shares. They need not be borrowed (and rarely are). They can be bought in the open market.

To destroy shares (called "redeem" in the industry), an AP delivers ETF shares to the fund company (which it destroys) in exchange for the basket of underlying securities.

If you work this out with pencil and paper (say, create your own ETF that owns 1 share of AAPl and 1 share of TSLA per share of the etf), you can understand the mechanics. And further, you can see that it is profitable to the APs to push the ETF's trading price toward nav, which is quite elegant.
This. So, as long as the ETF is not thinly traded, it works out well for most involved.
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Re: How are ETF shares generated?

Post by tcw »

senex wrote: Mon Sep 20, 2021 3:59 pm To create shares, an AP acquires enough shares to make a creation basket, and tenders them to the fund company in exchange for newly-minted ETF shares. They need not be borrowed (and rarely are). They can be bought in the open market.

To destroy shares (called "redeem" in the industry), an AP delivers ETF shares to the fund company (which it destroys) in exchange for the basket of underlying securities.

If you work this out with pencil and paper (say, create your own ETF that owns 1 share of AAPl and 1 share of TSLA per share of the etf), you can understand the mechanics. And further, you can see that it is profitable to the APs to push the ETF's trading price toward nav, which is quite elegant.

This is a nice explanation of how shares of of stocks can be exchanged for shares of an ETF, and vice versa.

I'm curious though: what about ETFs which have non-stock components? For example, leveraged ETFs like UPRO hold swaps, in addition to stocks. Looking at the UPRO holdings (https://www.proshares.com/funds/upro_da ... dings.html), it includes (for example) S&P 500 INDEX SWAP CITIBANK NA. Can the Authorized Participant just go to Citibank and buy or sell these swaps? (To be honest, I don't really understand exactly what these swaps are, but I suppose that's a separate issue.)
senex
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Re: How are ETF shares generated?

Post by senex »

Levered ETFs get more complicated.

We must introduce the concept of "holdings" vs "basket." The holdings are what the fund actually holds (owns). The basket is what collection of stuff the AP gives/gets from the fund when creating or redeeming shares. The holdings and basket need not be identical.

For a regular equity ETF, the basket and holdings are commonly identical, or nearly so. When redeeming SPY, the AP gets shares of AAPL, MSFT, etc.

For levered ETFs, the basket may contain only a subset of the holdings, or none at all (which is known as an "all cash create/redeem"). There is still an equal exchange (the per-share economic value is unchanged by a create/redeem), but it is typically done with cash instead of shares, because, as tcw mentioned, it's harder to acquire very specific swap contracts. Also, levered funds need to do a lot of internal gymnastics every day anyway (to maintain the daily leverage ratio), so it's not that difficult for them to take/give cash and do the buying/selling themselves.
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Re: How are ETF shares generated?

Post by alex_686 »

If you want a good nuts and bolts book on ETFs look up "A Comprehensive Guide to Exchange-Traded Funds" by Joanne M. Hill et. al.

The Kindle version is free and you should be able to find PDFs on the internet.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
retiringwhen
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Re: How are ETF shares generated?

Post by retiringwhen »

senex wrote: Tue Sep 21, 2021 11:47 am Levered ETFs get more complicated.

We must introduce the concept of "holdings" vs "basket." The holdings are what the fund actually holds (owns). The basket is what collection of stuff the AP gives/gets from the fund when creating or redeeming shares. The holdings and basket need not be identical.

For a regular equity ETF, the basket and holdings are commonly identical, or nearly so. When redeeming SPY, the AP gets shares of AAPL, MSFT, etc.

For levered ETFs, the basket may contain only a subset of the holdings, or none at all (which is known as an "all cash create/redeem"). There is still an equal exchange (the per-share economic value is unchanged by a create/redeem), but it is typically done with cash instead of shares, because, as tcw mentioned, it's harder to acquire very specific swap contracts. Also, levered funds need to do a lot of internal gymnastics every day anyway (to maintain the daily leverage ratio), so it's not that difficult for them to take/give cash and do the buying/selling themselves.
Even for large ETFs like VTI, the basket does not normally include any of the smallest 2000 stocks held by the fund. They only ask for the big ones. The ETF instead trades for the small stocks on their own time.
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