The Challenges of ETFs and its Underlying Constituents

Damien Wallace1, Ron P. McIver and Vikash Ramiah

School of Commerce,
University of South Australia,
Adelaide, South Australia, Australia

Abstract

Exchange Traded Funds (ETFs) have become one of the most innovative and popular
financial instruments with its diversification benefits at the core of its success. Nonetheless,
the inherent link between ETFs and its underlying securities has cast doubts on its usage. In
particular, volatility of both the physical asset and the derivative has been the subject of
discussion in the academic literature. In this book chapter, we (1) identify potential
challenges and weaknesses associated with the trading and operation of ETFs (2) discuss the
debate surrounding ETFs effect on the underlying constituents’ volatility, and (3) criticise
certain structures around this product. ETF is an important financial innovation; even so, the
challenges identified warrant further regulators and academic scrutiny.

Keywords: ETFs, Volatility, Equity, Risk, Return

Acknowledgements

The authors wish to acknowledge in the invaluable assistance of Belinda Wallace and Emma
Ramiah on this book chapter.

1
Corresponding Author: damien.wallace@unisa.edu.au
 The Challenges of ETFs and its Underlying Constituents

1. Introduction

Exchange traded funds are one of the finance industry's newest innovations. Their popularity

stems from tax benefits, ease of transaction, diversification benefits and low management

fees. ETFs generally track an underlying basket of stocks, bonds or commodities—

nonetheless, they are open to the implications/criticisms that are placed on the effects of

derivatives on the quality of the underlying securities prices. Trading activity in derivatives or

ETFs tend to create volatility in the underlying securities, with the spillover literature arguing

a unilateral flow between ETF trading activity and the underlying securities. The recent

volatility spillover effects casts doubts on the benefits of diversification and motivates us to

look at this product.

As shown in Figure 1, over the past 15 years the number of global ETFs has grown from a

small number to over 4800 by the end of 2016 (Etfgi.com, 2017). Currently, the global ETF

assets under management is estimated to be around USD 3.5 trillion while the volume traded

in the last 12 months is approximately USD 18.2 trillion. Much of this growth can be

attributed to tax benefits and lower management fees, both stemming from a passive

management style, and the ease of transaction whereby ETFs are listed on a stock exchange

similar to stocks. This popularity has accelerated the growth of ETFs into international

markets, specific sectors or themes, commodities and fixed income.

Another unique feature of ETFs is the high turnover ratio. For instance, the turnover ratio is

around 600 percent in the ETF market, while it is just 18 percent in the equity markets

(Ramiah et al., 2011). This number is immense by any standard and even in comparison to
 Damien Wallace, Ron P. McIver and Vikash Ramiah 2

the assets under management2. This turnover suggests a large portion of transactions in ETF

financial markets as within the US, the portion of total dollar trade volume attributable to

ETFs is roughly 35% (Sullivan and Xiong, 2012).

Clearly, the rapid growth and extensive trading activities of these securities have brought

them directly into the sights of regulators and market observers who have raised concerns that

ETFs may be related to stock market volatility. In light of the growth and trading of ETFs,

these concerns appear to be valid; however in this book chapter we look, not only at the

volatility concerns, but at other possible challenges. As a result, our chapter discusses the

debate and challenges surrounding ETFs. More specifically, we look at (1) the ability of

ETFs to correct mispricing due to limits to arbitrage; (2) market efficiency; (3) the

functioning of ETFs in the lens of liquidity of its underlying constituents; (4) market

manipulation; and (5) ETF volatility spillover to underlying constituents.

Our chapter is organized as follows. Section 2 describes the structure of ETFs and the

interactions of the main participants in ETF markets. Section 3 the challenges that ETFs face

and Section 4 concludes.

2. The Structure of ETFs

As ETFs are relatively new financial innovations, they are yet to be known and understood.

For this reason we start this book chapter by defining the terms and jargon used when

2
The assets under management at the end of 2015 was USD 2.87 trillion. The assets under management
was likely to be lower at the reference point of 30 July 2015. As such the 634% turnover is a conservative
figure. Irrespective, the turnover figure indicates a large and liquid market for ETFs.
3 The Challenges of ETFs and its Underlying Constituents

discussing ETFs. These terms include basket of securities, replication, full replication, partial

replication, ETF fund sponsors, Authorised Participant (AP), creation (redemption) process,

creation unit, Intraday Net Asset Value (iNAV) and continuous issuance. Table 1 provides an

explanation of these terms and we encourage the readers to familiarise themselves with these

terms as we use them extensively in the rest of the chapter.

ETFs are investment vehicles that issue shares which are listed on major global stock

exchanges and implicitly, this global network allows this instrument to be traded

continuously within a trading day. The vast majority of ETFs track predefined indices which

typically involves holding a basket of securities that aims to mimic the return of the

predefined index. This can be done through either partial or full replication of an index or

through derivative contracts that pay the return on the index.3

The creation of an ETF occurs in the primary market with ETF shares being issued through

an Initial Public Offering (IPO) similar to that of ordinary shares. ETF fund sponsors invite

large financial organisations to participate in the initial offering through expressions of

interest about the ETF fund. The organisations that agree to participate are called Authorised

Participants (APs) and to actively participate they must provide a basket of securities to the

ETF fund sponsors. In return, APs receive the equivalent value of their basket of securities in

terms of ETF shares from the fund sponsors. APs can either hold their ETF shares or sell

them on the secondary market.

3
Note that although this discussion relates to ETFs, there are products that utilise derivative contracts to
track a predefined index. These products are called exchange traded products (ETPs). The implications
discussed in this chapter for ETFs are broadly applicable to ETPs.
 Damien Wallace, Ron P. McIver and Vikash Ramiah 4

While the first offering for shares in the ETFs is through IPOs, the subsequent creation (or

redemption) of ETF shares is on an ad-hoc basis through a process known as continuous

issuance—this can happen at any time during trading hours. The continuous issuance occurs

when an AP requires more ETF shares. When an AP wants to acquire more ETF shares, the

financial organisation must buy the requisite ordinary shares (that match the creation unit of

the ETF) and deliver these shares to the issuer of the ETF for a fee—that is to the fund

sponsor. The fund sponsor, in return, will provide an equivalent number of new ETF shares

to the AP—this number of ETF shares equivalent is referred to as the creation unit. The

conversion of the total value of the basket of securities into the number of new ETF shares is

given by an arbitrary formula best described as a black box 4. The new number ETF shares

add to the number of outstanding ETF shares. The opposite occurs when the AP wishes to

redeem their ETF shares. This method is commonly called the creation or redemption

process. Figure 2 shows the movement of assets from each ETF market participant involved

in the creation and redemption process and the subsequent sale of ETF shares on the

secondary market. The secondary market, a stock exchange, is where retail investors and

brokers can buy or sell the ETF shares.

The creation and redemption process can occur due to mispricing of the price of the ETF

relative to its fair price as measured by Intraday Net Asset Value (iNAV). The iNAV is

calculated as the sum of the individual stock weights, multiplied by their current (market)

price, all divided by the number of ETF shares in a creation unit. The iNAV can be calculated

as:

4
In subsequent sections, we come back to this point where we argue that this is one of the challenges of
ETFs.
5 The Challenges of ETFs and its Underlying Constituents

∑ W j ,t P j ,t Where iNAV k , t is the Intraday Net Asset Value of the kth ETF at
j=1
iNAV k , t= (1) .
CU k

time t, W j ,t is the weight of jth stock in the ETF at time t, P j ,t is the price of the jth stock at

time t and CU k is the creation unit of the kth ETF. It should be noted that the CUk is the

arbitrary number disclosed in the prospectus of the IPO.

Mispricing occurs when the market price of the ETF differs from iNAV. When the market

price of the ETF is above (below) iNAV, the ETF is traded at a premium (discount). To take

advantage of the mispricing when ETFs are traded at a premium (discount), investors will

purchase (sell) underlying ordinary shares constituents that are within the ETF structure, and

simultaneously sell (buy) the ETF shares until ETF share price is equal to iNAV. Premiums

and discounts have been shown to exist in the US market. For instance, Ackert and Tian

(2000) document mispricing whilst Elton et al. (2002) observe both premiums and discounts.

3. ETF Challenges

This section’s focus is on the current challenges facing ETFs. The identification and

delineation of these challenges is paramount for retail and institutional investors to

understand the risks and implications involved with such investment. This section draws on

the extant literature on aspects such as arbitrage, ETF portfolio rebalancing, fund flows,

informational shocks, price discovery and informational efficiency.

3.1 Limits to Arbitrage

 Damien Wallace, Ron P. McIver and Vikash Ramiah 6

Arbitrage is one of the central tenets of finance, and occurs when prices, for the same asset in

two separate markets, diverge. Arbitrageurs within the ETF market exploit these price

differentials through the simultaneous purchase of ETF shares and the sale of the underlying

constituents, and vice versa, to realise a risk free profit. In doing so, this process enforces the

law of one price and keeps markets efficient. In reality, arbitrage has significant impediments

through market frictions and unobserved information.

Limits to arbitrage is one of the challenges in ETF markets. One of these limits is the cost

incurred each period when arbitrage positions are taken. We can define these costs as holding

cost, dividend payments, margin cost and cost of debt. Holding costs associated with limits to

arbitrage include opportunity costs for not receiving full interest on short positions,

idiosyncratic risk exposures and an opportunity cost of capital (Pontiff, 2006). Taking a short

position in either the ETF or the underlying constituents assumes the responsibility for

making dividend payments on the shorted security to the entity from whom the stock has

been borrowed. Additionally, short sales of any security occur through a margin account.

When short selling, borrowing of the security is a key component which usually attracts

interest payments. We argue that the reason for why mispricing persists is due to these costs

associated with taking an arbitrage transaction. We believe that arbitrage profit after these

costs are taken into account, is zero.

Another challenge is about the complexities and mispricing surrounding the constituents of

an index. For instance, when stocks are cross-listed the dynamics changes significantly. In the

US and overseas markets, stocks are traded on foreign stock exchanges through American

Depository Receipts (ADRs) and the ADR literature shows clear price discrepancies between
7 The Challenges of ETFs and its Underlying Constituents

the ADR and their underlying security (see Eun and Sabherwal, 2003; Suarez, 2005; Akram

et al., 2008; Pasquariello, 2008; Gagnon and Karoyli, 2010; Alsayed and McGroaty, 2012;

Buraschi et al., 2015; and Dey and Wang, 2012). Our major concern is that we do not know

how this influences the EFTs as the EFT literature is in its infancy stage. We believe that this

can be another source of mispricing in the ETF market.

Similar to equity markets, we find that the ‘size factor’ provides another challenge within

arbitrage opportunities of ETF literature. Within the US market, Ackert and Tian (2000)

show that medium size ETFs provide larger premiums and discounts than large size EFTs 5.

DeFusco et al. (2011) contribute to this size debate by confirming that premiums and

discounts are smaller for larger size ETFs but add that larger EFTs are more liquid. What we

have learnt from the equity literature is (1) smaller firms have higher betas and consequently

attracts higher return (and losses) and (2) investors demand a compensation for illiquid stocks

(illiquidity premium). Although, we agree with the findings of Ackert and Tian (2000) and

DeFusco et al. (2011), we argue it is premature to conclude that size and illiquidity premium

are the only two culprits simply because EFTs has derivative features. Furthermore, we

observe other factors that have not been considered within the ETF literature. For instance,

the number of analyst coverage on large indices (and therefore large ETFs) is larger than that

of smaller indices and consequently more information asymmetry is to be expected in the

smaller indices leading to a difference is premiums/discounts. We are convinced that more

research is required in this area before major conclusions can be drawn about this product.

5
It is fair to assume that larger indices leads to larger EFTs and vice versa.
 Damien Wallace, Ron P. McIver and Vikash Ramiah 8

Studies like Richie et al. (2008) argue more arbitrage opportunities exist during periods of

high market volatility. High market volatility is usually observed around both expected and

unexpected events—events which can be either firm-specific, industry specific, national and

international. Examples of these events are announcements of IPOs, mergers and

acquisitions, dividends, earnings, issues of new debt and equity, macroeconomic data,

terrorist activities, natural disasters, regulatory frameworks and many more. Whilst the

literature is correct in terms of more arbitrage opportunities around high volatility periods, we

do not observe an increase in the number of ETF market maker participants. This is because

the number of APs is restricted (given that it is a by invitation only from the fund sponsors)

and cannot be increased overnight. In other words, we believe that this restriction is a

structural flaw in the design of the EFT market.

3.2 Price Discovery and Informational Efficiency of ETFs

Where multiple securities track the same underlying asset, such as an index, the incorporation

of information into security prices is commonly called the price discovery process. In markets

that are perfect and frictionless, securities should react to new information simultaneously,

otherwise arbitrage opportunities may arise. However, markets are not perfect and frictionless

with different levels of transaction costs, latency and trading arrangements. This causes

markets to impound or react to new information quicker and more efficiently than other

markets. Securities that incorporate information quicker are said to lead the price discovery

process, or dominate other related securities. The market where information is incorporated

quickest is also the market where the ‘fair price’ is set. This is the best estimate of the value

of the security. This concept can be used to identify where price shocks will be incorporated

into price first, with less dominant securities prices moving to match the dominant security.
9 The Challenges of ETFs and its Underlying Constituents

For instance, if a macroeconomic shock occurs in a system that has three integrated securities

—an ETF and a futures contract that track the underlying index, and the index itself, it is

possible that the macroeconomic shock is incorporated into any one of these securities. If we

assume that the macroeconomic shock is incorporated, firstly, into the ETF. Through this

channel the underlying spot index and futures contract would react in response to this

informational incorporation in the ETF. The challenge with price discovery of ETFs is

identifying where information is incorporated into price, as this effects the transmission of

market influencing shocks.

Several studies investigate the price discovery of ETFs, futures and underlying indices and

find that price discovery has shifted from the futures dominating to a more equally

contributing scenario. For instance, Tse et al. (2006) investigate the DJIA index, both the

regular and mini sized futures and the ETF tracker fund, the Diamond ETF, with results

showing the futures contract contributes 69 percent to the price discovery process. This

indicates that any information hitting the market is, on average, first incorporated into the

futures contract, 69 percent of the time. This early challenge in identifying the security that

incorporated information has been partially alleviated with Hasbrouck (2003) who finds that

the ETF dominates the price discovery process. More recent studies indicate that the S&P

500 ETF and e-mini futures contract contribute equally to the price discovery process

(Wallace et al. 2014). The results indicate either the ETF or the futures contract could be the

location that identifies the fairest value of the asset. For investors, it is still difficult to

identify where the fair price is located.

 Damien Wallace, Ron P. McIver and Vikash Ramiah 10

Another challenge is the relative ability of ETFs and the underlying basket of securities to

move in concert. When ETFs and their underlying constituents move in concert, efficient

transmission of information from the ETF to the underlying constituent, or vice versa, occurs.

Greenwood (2007) investigate Japan’s Nikkei 225 stock index and show a distortion in the

comovements of stocks with other stocks due to overweighting of stocks. This is directly

applicable to ETFs as very few ETFs have equally weighted constituent stocks. Rarely, even

under full replication, do the ETF constituent weights exactly match the index weights, while

for partial replication the ETF constituent weights differ greatly. As information enters the

market, overweighted individual stocks in the ETF react, or comove, more than the

underweighted stocks in the ETF which leads to a distortion in the expected informational

impact on the ETF and underlying stocks. Broman (2016) confirms this distortion and blames

noise traders for its occurrence.

ETFs that exhibit low comovement with their underlying constituents are of concern to

investors as it is a potential for wide tracking error between the ETF and the underlying

constituents. The source of this low comovement, as indicated by Greenwood (2007), may be

due to an overweighting in some of the stocks within the index. The overweighting of the

stocks and the subsequent tracking of the index by ETFs expose ETF investors to higher

levels of systematic risk than normally expected in a diversified portfolio.

Another challenge that ETF fund sponsors face is further removal of limitations restricting

the tradability of ETFs. Removing market frictions such as transaction costs increase the

price discovery of ETFs which cause the fair price to be identified in the ETF market
11 The Challenges of ETFs and its Underlying Constituents

resulting in an increase in investors’ confidence in investors. We believe this is a vital test for

ETFs in growing their stature as an important financial asset.

3.3 ETF as a Cause of Liquidity Crisis for its Underlying Constituents

Liquidity is an important aspect in the efficient functioning of markets as it allows traders to

enter and exit markets with confidence and certainty. When liquidity is low, traders are

reluctant to enter as they may experience difficulties in exiting the market. Under those

scenarios, traders demand a higher compensation for this illiquidity premium. In the case of

the ETF, liquidity is not an issue as it is a liquid market. Nevertheless, a segment of the

literature have been accused ETFs of stealing the liquidity of the underlying constituents

(causing a liquidity crisis for the underlying constituents). In this section, we show the

ongoing debate about the ETF liquidity issue in the academic literature.

Earlier studies find the introduction of ETFs increases liquidity in their underlying

constituents. For instance, Hedge and McDermott (2004) investigate two highly liquid ETFs

that track the Dow Jones industrial average and the NASDAQ 100 index and their main

findings indicate liquidity of the underlying stocks improves after the introduction of the

ETF. They explain that the increase in liquidity is due to a decline in the cost of informed

trading. Few years later another study by Richie and Madura (2007) provided further

evidence in favour of an increase in liquidity. Richie and Madura explain that liquidity of the

underlying constituents improves following the creation of the ETF whereby the

improvement in liquidity is more pronounced in underlying constituents with lower

weightings in the ETF. Madura and Ngo (2008) contributes to this debate by investigating the
 Damien Wallace, Ron P. McIver and Vikash Ramiah 12

effects of ETFs on the dominant component stocks in the ETF—the stocks that have the

largest weighting in the ETF. They report positive relation between the creation of ETFs and

the value of the constituent stocks. They relate the valuation effects of constituent stocks

through the hypothesis that low liquidity constituent stocks will have higher valuation due to

the increase in liquidity after the creation of the ETF. De Winne et al. (2014) argue that

market makers tend to provide liquidity during period of low liquidity in the underlying

constituents.

More recent studies have challenged the findings of the earlier studies cited in the previous

paragraph and may be implying a potential liquid crisis for the underlying assets.

Interestingly, some papers show ETFs actually decrease liquidity in the underlying

constituents. For instance, Pan and Zeng (2017) explain that the conflicting structure of APs

in their dual role as market makers tend to consume more liquidity than they provide and in

order to reverse their transactions, they decrease liquidity. Pan and Zeng (2017) identify

another situation whereby ETFs hold relatively illiquid assets due to liquidity mis-match.

Another study by Marshall et al. (2017) has gone one step further to conclude that ETFs

creation does not help the liquidity of the underlying assets in a high-frequency environment.

When we consult the literature around the liquidity issues of EFTs, we find that a major

disagreement—in that we find no clear relationship about the effects of liquidity on the

underlying assets. Investors and policy makers will find it difficult to make a decision in this

unsettled environment. In this book chapter, we provide our opinion in this area and our

disclaimer is that we are not giving any financial advice. We believe that ETFs provide

liquidity for highly liquid underlying constituents but may steal liquidity from illiquid
13 The Challenges of ETFs and its Underlying Constituents

underlying constituents through its structural processes. For instance, at the time of IPOs or

creation, APs have to buy on the physical market thus creating more liquidity for stocks that

are very liquid. However, APs will be reluctant to buy illiquid stocks in the IPO and creation

phases.

3.4 Creation and Redemption through Fund Flows and Price Manipulation

The continuous creation and redemption processes are facilitated through APs (1) buying

constituent ordinary shares for the creation process and (2) selling ETFs shares for the

redemption process respectively. When APs buy the underlying constituents for a creation

unit, the aggregate dollar value of the underlying constituents is classified as a fund flow.

Specifically, creation of ETFs shares increases the value of the ETF which result in a fund

inflow, while redemptions of ETF shares reduce the ETF value—and is called a fund outflow.

A relatively small number of studies have investigated the creation and redemption process

from the perspective of fund flows. Clifford et al. (2014) indicate that ETF flow is a function

of the characteristics of an ETF, namely high volume, small spreads and high price/net asset

ratios. Broman and Shum (2016) clarifies the volume argument by showing that ETFs with

high (low) liquidity relative to their underlying securities, have higher (lower) short term fund

inflows (outflows). Such evidence indicates that liquidity attracts investors to the ETF,

possibly at the expense of the liquidity of the underlying constituents.

Other studies explores whether trading strategies can be developed around the ETF flows. For

instance, Staer (2016) investigate the relationship between ETF flows and the underlying
 Damien Wallace, Ron P. McIver and Vikash Ramiah 14

securities returns and document price pressure and price reversal patterns in the ETF

flow-return relationship. This finding suggests that economically significant returns

originating from ETF fund flows can be achieved. Osterhoff and Overkott (2016) investigate

ETF flows and their influence on underlying stock returns in the closing auction. Their

findings show that ETF flow related transactions affect the ordinary share price of the

underlying constituents. They show an economically significant effect on abnormal returns of

underlying stocks in the closing auction which is significantly pronounced in small stocks on

bullish trading days. They also imply that it is possible for APs to exploit this inefficiency by

means of active price manipulation during the closing auction. We find this possibility to be

illegal in nature as it is not in accordance with the fairness principles of the stock market.

Investors must be warned about this possibility and regulators must ensure that this

possibility does not happen.

An additional aspect related to the IPO, creation and redemption process that has not been

investigated in the ETF literature is the arbitrarily chosen number of ETFs shares assigned to

a creation unit. In the US, the Securities Exchange Commission (SEC) states that the creation

unit size for ETFs to “choose creation unit sizes that promote an arbitrage mechanism” and to

restrict ETFs from setting very high or low thresholds (SEC, 2008). Hence, during the

creation stage, fund sponsors can just declare an “ad-hoc’ number of ETF shares but do not

disclose how they reach this number. We show in Equation 1 that the fair price of the ETF

(through iNAV) is affected by the arbitrary number disclosed (chosen on an ad-hoc basis) in

the prospectus of the IPO. We argue in favour of more transparency around the arbitrary

number.
15 The Challenges of ETFs and its Underlying Constituents

3.5 Volatility and Volatility Spillover

Volatility is generally explained by public information (French and Roll, 1986), private

information (Barclay and Warner, 1993) or noise trading with volatility spillover occurring

when the volatility migrate to another instrument. In the case of ETFs, we find (1) that the

introduction of EFTs results in an increase in the volatility of the underlying constituents and

(2) that new evidence suggest that volatility is migrating to the underlying constituents from

the EFTs (spillover effects). One of the reasons for investors to use EFTs is for hedging

purposes, but its consequences implies an unknown increased in risk—we find this an

intriguing situation which warrants more investigation as we need to understand whether the

benefits from diversification outweigh the spillover effects. In this section, we review the

literature around volatility and volatility spillover.

In this paragraph, we look at studies that show an increase in the volatility of underlying

constituents. Lin and Chiang (2005) investigate the effects of the introduction of the Taiwan

top 50 ETF on its constituent’s volatility and show a clear increase in the component stocks

volatility after the establishment of the ETF. In addition, they show sectoral differences. For

example, they find the electronic and financial sectors which have significantly higher

number of constituent stocks exhibit higher volatility. On the other hand, Ben-David et al.

(2014) use ETF ownership to investigate the effects of ETFs on underlying constituents’

volatility—they find ordinary shares that are constituents of ETFs display a higher level of

volatility than similar ordinary shares that are not part of an ETF. Using a different approach,

Malamud (2015) develops a theoretical model based on the creation and redemption

mechanism for the transmission of volatilities and argues in favour of an increase in the

volatility of the underlying constituents.

 Damien Wallace, Ron P. McIver and Vikash Ramiah 16

As for the volatility spillover, Krause et al. (2014) in their investigation of nine US sector

ETFs find volatility spillovers from ETFs to their largest component stocks. In particular,

they find ETFs that are more liquid tend to have more volatility spillovers. Further, Krause

and Lien (2014) show that volatility spillovers originate from ETFs and spillover to the

underlying constituents stocks. Similar to Lin and Chiang (2005), they note a sectoral

difference in the spillover.

4.0 Conclusion

ETFs can easily be considered as one of the most important financial innovations of the past

few decades. The expansion of the ETF asset class and its use by both retail and institutional

investors is testament to this popularity. The ETFs reputation is driven, in part, by their

diversification potential, low management fees, tax benefits and high liquidity of the majority

of ETFs.

However, ETFs face a number of challenges. For instance, transaction costs, complexities

faced by the underlying assets, the size factor, structural flaws around the product,

information dissemination, high levels of market volatility, price manipulation and low

comovement/tracking error limit market participants’ ability to take advantage of the

mispricing between the ETF and its underlying constituents. Following our discussion in this

chapter, it is apparent that our understanding of this product through existing research raises

more questions than answers. Such observation is consistent with a relatively new product

and we conclude that more research is required in this area. The implication of existing
17 The Challenges of ETFs and its Underlying Constituents

research suggest that financial regulators have to revisit the structure of this product to make

it safer.

Although this product faces no liquidity issues, its consequences on the liquidity of its

underlying assets is a matter of concern. We conclude that ETFs enhance the liquidity of

liquid underlying assets but disfavours illiquid underlying assets. From an investors’ point of

view, this is an unintended benefit in that ETFs draw attention to illiquid stocks that the stock

exchange need to investigate—as to whether companies are meeting the liquidity

requirements of the exchange.

One of the consequences of ETFs is its effect on the volatility of its underlying constituents.

Although, we observe a growing literature indicating that the introduction of ETFs has

increased the volatility in underlying securities, we are well aware of counter arguments in

terms risk reduction originating from diversification. We conclude that it is too early to

decide which of these two conflicting effects is more applicable and as such, investors should

be aware of these two possible conflicting outcomes.

The recent studies in this area has increased the awareness of investors and regulators and to

that end we have seen more regulations around this product. Other challenges require the

attention of researchers/regulator as we need further understanding of this financial

instrument.
 Damien Wallace, Ron P. McIver and Vikash Ramiah 18

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 Damien Wallace, Ron P. McIver and Vikash Ramiah 22

Table 1: Glossary of Terms

Term Description

Basket of securities Each ETF is expected to closely track a pre-defined index. The

basket of securities is the set of shares that are used by the

ETF to mimic the return of the index.

Replication Replication relates to the strategy in which assets are held in

ETFs in order to replicate the chosen tracking index.

Full replication Full replication indicates that the securities held by the ETF

are direct representation of the securities and the weights in

the index.

Partial replication When it is difficult or inefficient for the ETF to hold all of the

securities in an index, only a portion of the securities in the

index are held in the ETF.

ETF fund sponsors ETF fund sponsors are fund managers that specialise in

managing ETF IPOs and the ETF funds. They are responsible

to set up the IPOs and are in charge of the creation and

redemption.

Authorised Participants A large institution involved with the initial public offering of

(AP) the ETF and the subsequent creation and redemption process.

An AP can also be a market maker for the ETF.

Term Description
23 The Challenges of ETFs and its Underlying Constituents

Creation (redemption) The creation process occurs when APs provide the ETF fund

process sponsor with the underlying constituent basket of ordinary

shares in exchange for ETFs shares. The opposing process, the

redemption process, involves the exchange of ETFs shares for

the underlying constituent basket of ordinary shares.

Creation unit A unique amount of ETF shares that will be received by the

AP in exchange for a basket of securities.

Intraday Net Asset Value iNAV is the fair price of the ETF and is generally an aggregate

(iNAV) price of the underlying constituents of the ETF. The

mathematical representation of the expected price of ETF units

is based on the weightings and price of its underlying

constituents.

Continuous issuance A term describing the process whereby APs create or redeem

ETF shares.
 Damien Wallace, Ron P. McIver and Vikash Ramiah 24

Figure 1: The growth, assets under management and number of ETFs/ETPs.

ETF Assets (US$ Bn) # ETFs

The Assets Under Management and Number of ETFs
4750
3250

4250

2750
3750

2250 3250

2750
1750
2250

1250 1750

1250
750

750

250
250

Source: etfgi.com
25 The Challenges of ETFs and its Underlying Constituents

Figure 2: Creation and Redemption of ETF

Primary Market Secondary Market

Create
Basket of Trade Trade Buy,Sell
underlying
ETF constituents Authorised Stock Broker Investor
Fund Sponsor Participants Exchange Adviser
ETF Shares

Redeem
ETF Shares

Basket of
underlying
constituents